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Managing my money
Managing my money

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5.2 Understanding savings products

Here you start to explore the different savings choices for a household that has surplus income or has budgeted to create surplus income. You begin to learn to make some important distinctions between savings products:

  • products that earn interest where the nominal value of the capital (the amount you put into the product) stays the same
  • investment products, which you look at later, that can make capital gains and capital losses, where the investment you make can subsequently go up and down in value.

There are thousands of different savings products available, and such choice can be daunting. Yet it’s possible to make sense of the choice with reference to available interest rates and the taxation of that interest. An understanding of these, as well as a clear idea about the reason for wanting to save, should provide enough background information to make a more informed decision about a product.

The financial services industry is required to show interest rates on all savings products so that they can be easily compared. You saw last week how interest rates on debt products are expressed as the Annual Percentage Rate (APR). For savings products the comparable rate is called the Annual Equivalent Rate (AER).

The AER and the APR are similar in principle, and allow a comparison of financial products with different payment patterns. The AER is the annual interest rate that savers receive, taking into account when interest is actually paid (for instance, annually, quarterly or monthly).

Week 4 also introduced the idea of real interest rates – thinking in real terms can help to show what’s happening to the value of savings over time. For example, the significance of a 5% interest rate on savings is dependent on the rate of inflation, and is very different at either 1% or 6%.

In the latter case, the real interest rate is actually negative, that is, your savings could buy less in a year’s time, even after the receipt of interest. Theoretically, this could cause some people to decide to consume more now and save less. Conversely, when inflation has been high in the UK, it can make people want to save more to make sure the real value of their savings is not reduced.

In the UK, only National Savings & Investments periodically offers an inflation-proofed savings product in the form of index-linked certificates. For example, holders of the 48th issue five-year certificates are guaranteed to get their original investment (their ‘capital’) back at the end of five years with interest equal to inflation over the period plus 0.5% a year, in other words a real return of 0.5%. Someone who invested £1000 in these five-year index-linked certificates on the first date of their issue in May 2011 would, on 6 April 2016, have found that they had a valuation of £1172.80, giving a nominal return since the start of the investment of 3.3% a year once inflation had been added to the real return.

At times of low inflation, the return on index-linked investments can seem unattractive, but they come into their own in periods when inflation is expected to be high. Most savings products do not offer inflation-proofed returns.

If you want to explore savings accounts further and the returns you receive on them why not access the MAS savings calculator [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] ?

Figure 3