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Cash investors need to understand the 'real interest rate'

Noel Whittaker
Noel Whittaker

IT'S a tough time right now for conservative investors, with interest rates at historic lows. 

If you are an investor who prefers to stay in cash, you need to understand the term 'real interest rate', which is the difference between the current inflation rate and the interest you are receiving.

Suppose you invest $100,000 at 4% when inflation is 3%.  The interest for the year would be $4000, but inflation would reduce the value of your investment by $3000, leaving you with a real rate of just one per cent.

That's bad enough if you are in a tax free pension fund, but the outcome is much worse if you have to pay tax.  For example, if you were in the 32.5% bracket, tax would take $1300, leaving you with a real after tax return of negative $300.  In other words, you've gone backwards.

It would have been a different matter if that same $100,000 had been invested in a growth asset (such as an equity trust or in property), and it achieved growth of 4% in one year as well as income of 4%.  Because growth assets are subject to capital gains tax, the 50% concession would have been taken off before tax was calculated.  This would have reduced the gain that was subject to tax from $4000 to $2000, and the overall tax would have been much lower.

In any event, no capital gains tax is payable until the asset is disposed of.  This maximises the compounding effect of annual growth because nothing needs to be withdrawn each year to pay tax.  Unfortunately, capital gain can never be guaranteed, so growth assets are not appropriate as short term investments.

Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. Email: noelwhit@gmail.com.

Topics:  cash rate inflation interest rate noel whittaker opinion



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