Cash ISA and interest rates
For almost 15 years, interest rates in the UK were so low that holding cash in any way shape or form made little or no sense, regardless of what inflation was doing.
The tax benefits of a Cash ISA were largely meaningless as returns were so low, any interest earned would largely be covered by the Savings Allowance which allows basic rate taxpayers to earn up to £1,000 in interest without paying any tax.
With rates generally running at between 0.7% and 1.2%, interest earnings on balances below £100k were usually covered by the Savings Allowance and, therefore, attracted no tax.
But over the past year, interest rates have increased to what savers (at least) would regard as much more acceptable levels.
Some providers are currently offering up to 4.25% on a 12-month fixed Cash ISA with average rates coming in around 3% even for instant access accounts.
This all changes the numbers dramatically and, equally importantly, raises the question of whether or not a Cash ISA is now more attractive than a Stocks and Shares ISA.
What is an ISA
Before we go any further, it’s probably worth explaining what an Individual Savings Account or ISA is.
ISA is a savings account that is exempt from tax - so you will not pay any tax on interest, income or gains made by the money that you have in your ISA.
They are available to all UK residents who are aged 18 or over and individuals can contribute a maximum (currently) of £20,000 each tax year. It is worth noting that the term ‘Individual Savings Account’ can be taken literally because you cannot have one in joint names.
There are broadly two different types of ISA that determine how the money that you have saved will be treated.
Cash ISA - your money will be held in cash.
Stocks and Shares ISA - your money will be invested (usually) on your behalf in a mix of shares and bonds.
Cash ISAs carry no risk because they are protected by the Financial Services Compensation Scheme (FSCS), whereas your money is at risk in a stocks and shares ISA.
Cash ISA or stocks and shares?
As mentioned above, for the past few years there has really only been one option due to extremely low-interest rates - and that was to have a stocks and shares ISA.
In fact, research by MoneyFarm shows that over the past 10 years, a cash ISA would have returned around 12% which, after taking into account inflation, meant a loss of 30% in real terms.
Stocks and shares ISAs on the other hand saw a real term gain (on average) of around 26% over the same period. Generally, stocks and shares will always outperform cash in the long term.
Even if, for example, interest rates had averaged 4% over the last 10 years then cash would have given a net, real terms return of just 9%.
So from a pure net return point of view, investing your ISA in stocks and shares is preferable. But… and it is a big ‘but’, investing in stocks and shares carries substantially more risk than cash and much more volatility.
And these are vital considerations that must be taken into account.
Your personal circumstances will dictate what is most suitable for you.
As a general rule of thumb, investing in stocks and shares over the long term makes sense whilst holding your money in cash makes more sense if you are thinking short term.
Naturally, what constitutes long and short-term is subjective, but we would suggest that stocks and shares investing should be for a minimum of 5 years.
This is because dipping in and out of stocks and shares investments exposes your money to greater volatility risks - meaning you can crystalise losses that may be mitigated or reversed if the investment was held for a longer period.
A popular key phrase is ‘time in the market, not timing the market’:
Time in the market is investing.
Timing the market is speculating.
So if you think you may need to spend your savings in the next five years, cash may be more sensible. If you don’t think you’ll need the money in the next 5 years, stocks and shares may well prove attractive.
Websites like the Money Saving Expert are a great way to find the best Cash ISA rates that are available at any one time.