CPI and inflation, why you can’t just keep your money in cash

Everyone knows that saving money is good. Having savings means you can weather any unexpected expenses and be confident you are preparing for your future.

But what happens once your savings start to become substantial? In this context, substantial refers to any amount that would cover greater than 3 months of living expenses.

In this article I’ll explain why you need a plan for your money and why you can’t just leave it in a bank account.

Why shouldn’t I leave my money in a bank account?

If you have a large amount of savings in a bank account, you may effectively be losing money.

This is because of the effect of inflation. Inflation is the term used to describe the rise in cost of living. In basic terms, every year the cost of living goes up meaning that to have the same amount of buying power you had last year, you need more money this year.

Inflation is measured by the Consumer Price Index (CPI) which takes a standard list of items people regularly buy, and measures how much they have increased in cost year on year.

The criticism of the CPI measure is in many instances, it’s outdated. The ‘standard list of items’ it addresses may not have necessarily increased (such as bread and milk), but things like technology costs, government levies and power costs have risen substantially.

If you have your money in a bank account, you may be earning interest. In theory, this is meant to offset any inflation which is occurring. The problem with this is, that inflation is far exceeding your interest rate, meaning each year you leave money in your bank account, you have less buying power with that money.

In can be a tough pill to swallow to know you are going backwards by simply saving money.

So what should I do with my savings?

Working out what to do with your savings is a challenging task and is dependent on your particular circumstances. That being said, there are a few steps I go through to see if there are any better opportunities to make use of your savings.

1. Consumer Debt/Credit Cards

The first place you may want to consider putting your savings is paying off any consumer debt. Depending on how much interest you pay on your loans, you may find that paying off your debt is better than having savings. This is because the interest payable likely far exceeds any interest you are earning in your bank account.

2. Mortgage

Once you’ve paid out all of your consumer debt, you may want to consider putting any savings onto your mortgage. There are effectively two ways you can do this:

• Make extra repayments onto your loan; or
• Make payments into an offset account (if your loan has one).

For anyone who has good savings habits, the preferred option is to put your money into an offset account. An offset account is like a normal bank account except the money in the account ‘offsets’ the interest you are paying on your loan.

If you don’t have an offset account, you may wish to put the money direct on your loan. Be aware however that once you pay money onto your loan, you may not always be able to redraw it. So check with your bank the terms and conditions before taking any action.

3. Investment

Paying off your mortgage is a great way of utilising your money, but as mortgage rates go down, your ‘bang for buck’ is reduced substantially.

For example, if your mortgage rate is 2.5%, every extra dollar you pay on your mortgage gives you a 2.5% return. This alone may not be enough to help you beat inflation and grow your wealth. In this instance you may want to consider investing some of your money.

The topic of investments is broad and outside the scope of this article. If you’re looking for articles on investing, check out our blogs on the topic.

Needless to say, if you do want to grow your wealth and get ahead, you will need a plan to invest at some point in your life.

Where to next?

Whether you choose to pay off consumer debt, pay off your mortgage or start investing will depend on where you are at in your financial journey. If you’re finding yourself confused on where to go next, please don’t hesitate to reach out.

This post is from our resident Financial Planner Ben Brett, check out his details in the About Us section.

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Posted in: Ben Brett, Investments