Many of us are programmed from an early age to SAVE YOUR MONEY IN THE BANK!!
Our parents, family members and teachers program us to thinking that in order to get anywhere in life we need to earn money, save it in the bank, then purchase the item we need, be it a car, property, holiday…. Whatever.
The main issue with this theory is that by leaving you money in the bank, year after year after year you are actually losing money….. let me explain.
Say you have $100,000 sitting in a savings account with a financial institution. Over the past year the average rate of return was around 3.0%pa. So that means that after 12 months you will have a balance of $103,557 (Obviously this interest scenario is compounding with no regular deposits). Now that interest that you have earned over that 12 months period is $3,557, great you may say, I just made $3,557 in that 12 Month period for doing nothing at all!!!! WRONG…….
You see you now need to declare the $3,557 as part of your income, if you are a middle income earner you will pay about 37% tax on this, that leaves you with $2,241 after tax. Mmmm ok you might say, well at least I made something for nothing, right? WRONG again………
Did you know that because your money has been sitting idle for 12 months it is now NOT actually worth $100,000 anymore? This is due to inflation.
Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar you own buys a smaller percentage of a good or service.
Now the average rate of inflation over the past few years has been 2.5 – 3%.
So what does this mean you say?
Well what it means is that the Car, boat, holiday etc that you could have purchased 12 months ago will now cost you an extra 3%. If the interest rate is equal to the inflation rate then it would be like having a small faucet pouring water back into your bucket at exactly the rate it was leaking out, then take out the tax, so you are actually losing money!
Yes but how does that affect the above scenario?
The $102,241 that you now have sitting in the bank after paying tax has not grown enough to compete with inflation, you would have needed $103,000 after tax in order to have broken even (Assuming inflation rate of 3%).
Unfortunately, compound inflation is just like compound interest working against you. When you look at the effects of 3% inflation on your savings over 25 years we find that prices will have more than doubled and you will need $209.38 to buy the same basket of goods that $100 would buy 25 years earlier.
How does this affect me and property, what else can I do?
If you invested your $100k in a property in Sydney 12 months ago in 2013 and purchased a $500k house as an investment, it could now be worth over $550k ( Assuming a growth rate of 10%). That’s an increase of $50k. If you were to refinance this property at 80% LVR you may be able to access $40k in equity. Basically you have just used your $100k to generate $40k of accessible equity ($ CASH $) in your property in 12 months. (Note we have not factored buy costs etc).
Note:
Australian house prices have increased at the average annual rate of 8.4%. This implies that over the last 30 years property has doubled on average every 8.5 years.
In summary you can see what affect inflation has on your savings and how investing in property can provide some protection against inflation and offer strong capital growth as well. I am not saying that you should not save, cash gives you options and flexibility and is the foundation for kicking off a strong investment portfolio; however look at other areas of financial growth as well.
I have never met anyone who has saved their way to millions by squirreling away their pennies……. However I have met many successful people who have used their money and equity to build a profitable property portfolio…..