Thursday, September 29, 2011

Low Interest Rates on Savings Compare Well to the Past

People with cash savings and GICs often complain about the low interest rates available today. A Yahoo Finance article goes so far as to ask what’s the use of saving money? However, the higher interest rates of the past are nowhere near as good as they look.

In 1981, the average short-term government bond rates were about 16%. This looks pretty good compared to a 2% GIC today. However, we should take into account taxes. Assuming a 40% tax rate, these returns drop to 9.6% and 1.2%. The past still looks good. But, what happens if we take into account inflation? The inflation rate in 1981 was 12.5% and the current inflation rate is about 3%. So, savings lost about 3% in 1981 and lose about 2% today.

Comparatively speaking, interest rates on savings today don’t look so bad compared to the past. Savers in 1981 thought they were making money, but they weren’t; they were effectively spending their principal. Perhaps the larger lesson is that short-term cash savings rarely grow in real after tax terms.

5 comments:

  1. Wow, a TFSA makes a huge difference here. Skip the taxes, and the equation changes dramatically.

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  2. @Patrick: Avoiding taxes definitely makes a big difference. However, even then, the real returns on cash savings will never look as dramatic as the nominal returns.

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  3. You are right to compare short-term bonds to inflation (which was also short-term). I heard from a gentleman who retired in the early 80s and bought an annuity. These days, he feels very lucky to have locked in at astronomical rates. I recognize, however, that he was an exception.

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  4. @Robert: The equation can be much different when locking in for the long term. This can lead to bigger upside and bigger downside. I had one family member many years ago who boguht CSBs with very high returns (I seem to remember 19%, but I'm not sure any more). When it came time to roll the CSBs over to new CSBs she was shocked to learn how much less interest she'd have to live on.

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  5. I do not know how I missed this post but good to know from many ways. Tax and inflation we should look at worth of money from those two points too.

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