After a decade of low interest rates, some investors may be feeling upbeat about cash ISA rates at the present time. After all, it’s possible to obtain around 1.5%, with the potential for this level to rise should interest rates increase in the coming years.
However, with inflation standing at 1.8%, even a 1.5% tax-free return is losing an individual money in real terms each year. As such, saving through a cash ISA could be a means of destroying wealth over the long run, rather than creating it.
Real returns Even though inflation has fallen to a two-year low, it continues to be ahead of the returns on cash ISAs. As such, every £1 invested through a cash ISA is currently losing spending power. Although this isn’t generally a significant issue over the short term, in the long term it can lead to a deterioration in an individual’s wealth.
Although interest rates could move higher in the coming years, their future direction will largely be dependent upon the rate of inflation. If inflation moves higher, then interest rates and the return on cash ISAs could follow. However, there is still a good chance that inflation will remain at an elevated level compared to interest rates, since the Bank of England may adopt a cautious stance on monetary policy in order to support the economy during the Brexit process.
Capital management Of course, having some cash savings is a good idea. They can provide capital in case of emergency, as well as offer peace of mind should other investments experience a challenging period.
However, having a bog-standard savings account is likely to be just as appealing as a cash ISA for most people. With up to £1,000 of interest income per year not being subject to tax, an individual would need to have £67,000 in cash in order to make the tax avoidance status of a cash ISA worthwhile. As such, it may be difficult to justify a cash ISA even for individuals who would prefer to keep sizeable amounts of cash on hand.
Investing For individuals who already have adequate cash reserves, as well as a long-term time horizon, investing in the stock market could be a superior means of creating wealth. The income return on the FTSE 100 is around three times that of a cash ISA, while its capital growth potential could mean that its total return is even more enticing.
Certainly, there’s a risk the FTSE 100 will decline, and this could lead to paper losses in the short term. But with the index having always recovered from even the most challenging bear markets, investing in it over the long run seems to be a worthwhile move. Otherwise, what may seem like a significant amount of cash today could prove to be far less attractive in the long run due to the negative impact of inflation.
Motley Fool UK 2019