The 5 basics of good finances
Do your eyes glaze over when it comes to monetary sums? You’re not alone. James Connington has put together a cheat sheet
One current account pays annual interest of 2pc on your balance, while another pays a flat rate of £5 a month if you maintain a minimum balance. Which one is the better deal? For some, this is a straightforward calculation. But many Britons struggle with day-to-day maths, and find managing their money a daunting task. Some 49pc of the working-age population have a numeracy level that would be expected of primary schoolchildren, according to National Numeracy, the education charity, ahead of the inaugural National Numeracy Day tomorrow.
That means around 17million people would probably not know that – to answer the earlier example – the flat rate of £5 per month is better on balances below £3,000. On £3,000 or more, the 2pc interest adds up to more than £60 in a year.
A lack of numeracy skills is costing the UK economy £20bn in lost productivity, according to National Numeracy, and can cost individuals thousands each year. Leaving long-term savings languishing in cash accounts paying next to no interest is particularly damaging.
If you had £10,000 in a savings account paying 0.05pc interest – a rate offered by multiple large banks – you would earn just £50.11 in interest over 10 years. At the top fixed savings bond rate of 2.7pc, if interest was reinvested, you would earn £3,052.82 over the 10 years.
Failing to understand the comparable cost of different financial services offered in pounds-and-pence fees versus percentage-based fees can mean paying far more than necessary. Debt, too, can quickly spiral out of control for those who don’t understand how charges work or how to prioritise repayments.
Russell Winnard, of charity Young Money (formerly the Personal Finance Education Group), said: “For both adults and young people, the most significant gaps are long-term finances: investments, savings, pensions, insurance.”
He said that when the Government added personal finance to the national curriculum in 2014, it then failed to back it up with appropriate funding. “I was recently giving a talk to a group of 16- to 24-year-olds. I asked them what they would do if they ran out of money a week before payday – every single one of them pointed out the window to the payday loan shop across the road. They didn’t even consider other options,” he said.
Behaviour plays a role in people’s lack of understanding of compound interest, ability to pick the right account or service, and knowledge of how to set a budget.
Dr Martin Upton, director of the Open University’s Centre for the Public Understanding of Finance, said: “There is chronic inertia when it comes to dealing with finances, a dislike of delayed rewards, which impairs decisions about the future, and a dislike of complexity. When it comes to choosing between financial services, people will opt for the simplest option, even if it’s the most expensive.”
He added that many people failed to understand the probability of certain events in their life occurring, and incorrectly viewed them as unexpected costs. “If you look statistically, most events are quite expected. Take replacing a washing machine, for example. How many do you own in a lifetime? Having to replace one is not unexpected.”
These are some key things to get your head around: your own money cheat sheet.
Compound interest
When you choose to leave your savings in an account paying nothing, instead of investing it or putting it into a top savings account, you are losing out on more than you think.
If you have £1,000 and put it into an account paying 3pc, you will earn £30 in interest in the first year. In the second year, assuming the £30 is added to the £1,000 rather than being paid out, you would earn 3pc on £1,030, or £30.90. By year 10, your annual interest would be up to £52.61. This is because you are able to earn interest on the interest you have previously earned. Over long time periods, the results can be significant, particularly when it comes to investing.
Fees and costs
Always work out exactly what services will cost you in a comparable format.
Don’t assume that because a fee seems like a low percentage or pounds-and-pence figure that it is the best deal. If you have a stocks and shares Isa containing £10,000, a flat service charge of £100 a year is far more expensive than a percentagebased charge of 0.25pc annually (£25 a year). For a £100,000 portfolio, however, the situation is reversed.
A payday loan that costs £50 to borrow £400 for a week is equivalent to an annual interest rate of 650pc – far beyond the cost of credit cards, overdrafts, bank loans, or a credit union loan.
Isa and pension tax relief
Not taking advantage of Isas and pensions is an expensive mistake.
With a pension, you automatically receive upfront tax relief that boosts the value of any contribution.
For a basic-rate payer to put £100 into their pension, they only need to make an £80 contribution. A higher-rate payer – those earning between £46,350 and £150,000 a year – only needs to pay £60 to achieve the same £100 of pension savings. If it is a workplace pension, your employer will automatically claim the extra tax relief for you. On a personal pension, you will likely have to claim it back yourself.
Even people who don’t earn enough to pay any income tax can
receive tax relief at the basic rate. Including tax relief, these nil-rate payers can make up to £3,600 of pension contributions a year, tax free. With an Isa, any interest or investment returns earned are free of capital gains tax, dividend income from shares is not subject to tax, and there is no tax to pay when you take the money out again.
Pension withdrawals are liable for income tax, aside from 25pc of the pot, which can be taken tax-free.
Switching providers
When fixed-term deals with the companies that provide your energy, insurance, mortgage and savings come to an end, you are typically shunted onto a much worse deal.
Moving energy supplier saves consumers an average of £290 a year, according to comparison service uswitch, and mortgage borrowers who switch to a new fixed-rate deal can save an average of £90 a month. Paying attention and switching to a new deal can save you thousands. And in many cases, such as moving bank account or energy provider, the process is automated.
The impact of inflation
Understanding inflation is important for putting the returns from savings and investments into context.
If inflation, as measured by the consumer price index (CPI), is at 3pc, and your savings account is paying 1pc, the value of your savings is being eroded at a rate of 2pc a year.
‘There is chronic inertia when it comes to dealing with finances’
ANSWERS: Two for the price of one; They are the same value; 5.06%; Around £48; 11.57 days