Don't be preoccupied with the interest rate, concentrate on actually saving more of your income if you can
Whenever I meet people, especially that age group between 18-34 known as millennials, and we begin to talk about different savings accounts, they invariably ask about interest rates, what is the best rate available and who is it with.
It seems to me that they are fixated with the rate, as if it is critical to their long-term success. I get the sense from some that, unless the return is very good, well then what’s the point in saving at all? It’s just not worth the effort when the best you can get is about 2%.
Regardless of what age you are, it’s only natural to want to get the best return for the effort you are putting into saving in the first place. You could use that money for other things, so you want to be rewarded for your commitment. But the secret to building up your account balance has more to do with your savings rate than the rate your savings are earning.
In other words, the amount of money you save is more important than the account you save into and its interest rate.
For an interest rate to make any difference, your first have to have a reasonable amount saved, and the interest rate isn’t going to do that for you, the amount you save is. It’s only when you have saved a significant amount that the rate of return becomes important, but it is largely irrelevant I would say for the first ten years of your savings life, because you are starting off with so little money.
Sometimes people try to take short cuts when it comes to saving money and are looking for the quickest way they can get to a certain amount whatever that number is. They want the interest rate to do the heavy lifting for them, but they are very much mistaken if they think it will. They focus on the thing that doesn’t matter early on (interest rate) rather than focusing on the thing that really does (the amount they save each month).
So, the interest rate and your savings rate are not the same, they are not even close, your savings rate is much more important. To illustrate this for you, let’s look at two different people.
Emily falls under the heading of ‘Large savings/low returns. If she saves €500 per month at a rate of 1%, in five years’ time she will have €30,775.15 in her account.
Sarah falls into the ‘low savings rate/high returns’ category. If she saves €200 per month and manages to get an incredible return of 7% each year. In five years’ time, she will have €14,402.11 in her account.
You can see the difference between both scenarios is significant, and whilst getting a great return on your money is nice, the amount you save is the key.
It doesn’t take a rocket scientist to work out that the amount you save has more of an impact than the rate you receive. Clearly €500 will grow faster than €200 per month, but unfortunately, I still come across lots of people who believe the interest rate is more important.
Last week, I met a gentleman who was 30 years old and had no savings whatsoever. He had a good income but an even better social life, but he thought it was about time he got serious with his money.
His first question to me was about crypto- currencies and how would he go about investing in them. Now this is a guy who had €0 in his savings account, and when I asked him why we wanted to start off saving by way of crypto-currencies, he told me about how a friend of his did so recently, and had doubled his money over a short space of time.
How much did his friend invest I asked? And he replied €1,000.
So, he got a return of 100% and turned €1,000 into €2,000 and I’m wondering will this extra €1,000 change his life? Probably not, and that’s not to belittle his achievement, but in the overall scheme of things, that extra €1,000 isn’t going to move the dial that much.
What will, is saving as much of your income as you can, living below your means, avoiding debt and investing wisely. That’s the class I would take if I was him, not the, how to invest in crypto currencies one.
Remember, if you can increase your savings, even by a small margin, it has a much bigger impact than a corresponding increase in the rate of return.
If this young gentleman I met saved, 1% of his income but was able to get a 10% return it would still be much less, four times less in fact, than if he was able to save 5% of his income with a 2% return. He would be able to take a drop of 8% in his savings rate, if he increased his savings rate by 4%.
What this tells me is that you should focus only on what you can control. Anyone who is saving should realise the only way they will achieve their target is down to them and the amount they save each month.
You can’t control how the stock market or crypto currencies will perform, so the take away is to maximise the things you have control over, and save as much as you can, by reducing your expenses as much as you can.
The larger the spread between your income and expenses the more you can save each month, and that’s what you need to focus on.
So my advice to savers is not to overplay the importance of what your annual rate of return is. Don’t think it is critical to your success and don’t spend too much of your energy on what it is. If you want to build up your savings, there is only way you can do that and that is by brute savings, nothing else. Focus on it, and once you have built up a sizeable amount, then look at trying to improve on your rate.
Liam Croke is MD of Harmonics Financial Ltd,
based in Plassey. He can be contacted at email@example.com or www.harmonics.ie