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£500 to invest? I’d ditch the Cash ISA and buy the FTSE 100

A Cash ISA can be a great tool to save for the future. These tax-efficient products allow you to save up to £20,000 a year with no further tax to pay on interest received. You don’t even need to declare the ISA on your tax return.

However, in recent years, the returns available on Cash ISA’s have plunged. Today, the best flexible short-term product on the market offers an interest rate of just 1.3%.

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You can get a bit more of a return on your money if you’re willing to lock it up. The best two-year fixed-rate product offers an interest rate of 1.5%.

The additional interest hardly makes up for the risk of locking your money away. With this being the case, instead of opening a Cash ISA, most investors could be better off investing their money in the FTSE 100.

More income

Compared to every single Cash ISA on the market, the Footsie 100 offers a much higher level of income. It currently supports an average dividend yield of 4.3%. That’s an average of all the index’s 100 constituents, which suggests it’s a pretty stable and predictable income.

Furthermore, over the past three decades, the index has produced an average return for investors in the region of 9% per year. That’s including both income and capital growth.

Although it isn’t easy to tell what the future holds for the stock market in the short term, over the long run, the market’s performance is easier to predict. Indeed, it’s highly likely the global economy will be bigger in 10 or 20 years than it is today. This implies the index should be higher as well.

As more than 70% of the FTSE 100’s profits come from outside the UK, assuming the earnings of the index’s constituents continue to grow in line with inflation, that’s around 2-3% per year. It’s highly likely the FTSE 100 will produce capital gains at the same rate.

Including the current dividend yield of 4.3%, these numbers suggest the index could return as much as 7.3% per annum going forward. That’s below the historical average, but still highly attractive compared to the 1.3% on offer from the market’s best Cash ISA.

The better buy

Therefore, if you’ve £500 of savings to invest today, it might be better to put this money in the FTSE 100 instead of opening a Cash ISA.

£500 invested at an annual rate of 7.3% would grow to be worth £2,143 after 20 years of saving. Meanwhile, the same £500 invested in a Cash ISA, earning just 1.3% per annum, would be worth only £648. These numbers clearly illustrate why the FTSE 100 is the better investment. This is especially true over the long term.

There’s also the impact of inflation to consider. With inflation currently running around 2% per year, this suggests the real (after inflation) rate of return a saver will receive is -0.7%.

That means your money will be losing purchasing power every year. The real rate of return for the FTSE 100, using the figures above, will be 5.3%.

That’s just another reason why the FTSE 100 is the clear winner.

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.