Sometimes it feels like every year there is a new financial product on the market. This is most true of loan products – the rise of payday loans, and hire-to-buy loans are just two recent examples. But there are also plenty of financial products for people with a little money to spare, rather than a little money short. ISAs, Regular Savers Accounts, Investments. If you have a bit of cash, what is the best thing to do with it?
The Difference between Saving and Investing
Not everyone is entirely clear on what the difference is between saving and investing, and it is very important to understand the difference when you are deciding which is best for your situation.
SAVING: Putting aside some money, bit by bit, either by setting it aside and not spending it, or by putting it into a cash product, such as an ISA or a Savings Account.
INVESTING: Using your money by buying things that you believe will increase in value, so that you can sell it for a profit later on.
It is important to note that when you put money into a cash product, your bank will use that money to invest for themselves, and that is why they can pay you a return. This return is likely to be much less than the bank actually made with your money, but it is also guaranteed (depending on your product).
The Traditional Rules: Save first, Invest second
Broadly speaking, saving is seen to be the secure, safer option, while investing is thought to bring much higher returns. This has led to the development of some fundamental Rules
Step One: Save an Emergency Fund of 6 Months Living Expenses
Your first thought, if you are lucky enough to have some extra cash, should be to create an emergency fund. Generally, this should be the amount you need to live on for 6 months, or longer, including housing, bills, food, and recreation (for yourself and any dependents you have).
So, if you spend about £800 a month, make sure you have at least £4800 put aside which can be accessed on a moment’s notice. This should protect you if you have a sudden expense, or lose your income suddenly.
Step Two: Save for a goal under 10 years away
On top of this, it is generally accepted that, if you can, you should save at least 10% of your monthly earnings. You might want to think of a short-term goal (a goal under ten years away) that you want to achieve. This may be a new car or a deposit on a home.
So, if you earn £18,000 a year after tax, which is £1,500 a month, make sure you save £150 each month. By the end of the year, you will have £1,800 + interest. In five years, that would be £9,000 + interest, which should be enough for a deposit on a £180,000 home. With a partner who has done the same, you can save for a home of £360,000.
Step Three: Invest
If you are lucky to still have money after all that saving, now is the time to think about investing.
You should always think of investing as a long-term project. Any amount of money that you are going to need within five to ten years, should be saved for, rather than invested for, because investments can go down as well as up, and you are waiting to see the long-term growth increase your money.
This makes investing suitable for pensions, your children’s university, or wedding, funds (if they are still very young), and other such long-term goals.
But: Interest Rates vs Inflation
The main reason that investing is considered to be better than savings for long-term goals is the effect of inflation. Due to inflation, a sum of money slowly becomes worth less over time.
For example, if you put £10,000 aside in 2017, and the inflation rate is 3%, your savings will be worth around £5,400 in 2037. To put that another way, in 2037, to be able to buy the same things you could have bought in 2017 with £10,000, you would need to have around £17,000.
This means, you would need a savings interest rate of 3% to simply keep your money from losing value.
This leads us to some very non-traditional advice for the situation that we currently find ourselves in. If you can, investing is a safer bet than saving, even for medium-to-short term goals. But still riskier than saving.
This is because we are in a very interesting, and difficult time. Inflation has reached 3%, but the Bank of England’s base rate remains at a measly 0.25%. This means that almost all banks have savings rates which are below the inflation rate, meaning your money is almost guaranteed to lose value.
Due to short-term volatility, it is still not advised to invest for goals which are less than 5 years away, and definitely do not invest for goals which are a mere 3 years away, but, depending on how comfortable you are with risk, it may be worth looking into investments (even for that house deposit).
No matter what you chose, remember to learn how to invest before you dive in. Important risk controls, such as diversification, could seriously save you from disaster.