photo: G & A Sattler

So lots of my friends have been complaining about interest rates over the last weeks or so. The Bank of England has dropped base interest rates from 5.75% where they were just 6 months ago to 1.0% today. For savers, that also means interest rates have been cut which is bad news for everybody who is saving for a house/college/etc. Right?

Not really. The Times discussed this very recently. It’s no good looking at the nominal interest rate which is advertised by your bank or the Bank of England as it is meaningless. What’s important is the real interest rate. Let me explain.

Let us take a basket of goods which we define to be representative of your expenditure. The basket of goods has a cost of £100 this year.

If we have inflation of 5%, that means the same basket of goods would cost £105 next year.

What if you decide, instead of buying a basket of goods today, you choose to put your money in a savings account earning 5%? Well, the £100 you invest will have turned into £105. When you come to spend your money, all you’ll be able to buy is a basket of goods. You’ll have nothing left over. In real physical terms, you haven’t gained anything from saving as the amount you can consume has stayed the same.

Hopefully this example illustrates that the important thing is **real interest rates**. Whilst nominal (advertised) interest rates are at the lowest point in yonks, real interest rates aren’t too bad as inflation is very low.

Let’s take a look at nominal interest rates and RPI inflation over the last few years:

We see that it was pretty bad for savers towards the end of 2008 as inflation totally eroded any interest being earnt. However, with inflation now very close to zero, this is no longer the case. This is more clearly illustrated in a graph of real interest rates:

As you can see, real interest rates are climbing back up to around 1.5% where they’ve been for the last couple of years.

Conclusions:

- Whilst it appears that savers are losing out, they’re not doing too badly considering the drop in inflation.
- Your savings for college are still growing. And if you’re saving for a house, you’re also benefiting from the huge drops in house prices.
- The low interest rates shouldn’t be encouraging you to borrow. After all, if a house is losing 10% of it’s value each year and you’re paying 1% interest on the mortgage, you’re paying an effective mortgage rate of 11%. That’s a much higher rate than a few years ago when house price inflation would essentially pay off the interest on your mortgage.