Last week, you may have heard that the Bank of England’s monetary policy committee voted by 7-2 to hold the main rate at 0.75%, following weak economic data. This was contrary to expectations the rate would be cut.
Some newspapers commented that the decision would be well received by savers, but not by those with loans or mortgages.
Here’s what I think.
The main rate
The reason why the Bank of England’s main rate gathers so much attention is that high street banks often use it as a reference point when setting their own interest rates for loans, mortgages, and savings accounts.
Therefore, when the rate is held steady rather than cut, those with loans and mortgages may be disheartened, as the interest rate they pay will likely remain the same. Likewise, those with savings accounts or Cash ISAs might be pleased that the interest they receive will likely not be cut.
Mark Carner, the departing governor of the Bank, stated that “although the global economy looks to be recovering, caution is warranted.”
Although the changes in rate are often small, they can make a huge difference to an individual’s wealth. After all, as Albert Einstein allegedly said: “compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.”
With compounding, you earn interest on interest. Or, you pay interest on interest. Think of it as a snowball that keeps on rolling.
You might have been advised by a relative or friend to overpay your mortgage with any spare cash you have. There is an argument for doing this. The more you pay, the less time your debt has to compound.
Newspapers said that a rate cut would be bad for savers, meaning people with savings accounts and Cash ISAs. Not those of us who invest in stocks and shares.
Like many of us, I was hoping the interest rate would be cut. This is because a rate cut can sometimes help propel the stock market, as people use their spare cash to invest or to buy more products from companies that I own shares in.
Our friend – compound interest – rears its head again. Last year the FTSE 100 returned approximately 11%.
If we compare that to a two-year fixed standard mortgage from high street bank HSBC – currently 1.79% for a maximum loan of £400,000 (90% loan to value), followed by a 4.19% variable rate – we can see that investing the money in the market last year probably would have been in our favour.
In fact, over the past 25 years, which is the length of some mortgage terms, the stock market has returned roughly 140%.
Regardless of whether the Bank of England’s main rate is raised, held or lowered, I believe the returns from the market will be greater than any Cash ISA, especially when dividends are added into the mix.
With interest rates at the level they are today, it might make sense to invest the money rather than overpay the mortgage. I would rather harness the power of compound interest.
T Sligo has no position in any of the shares mentioned. The Motley Fool UK has recommended HSBC Holdings. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.