Dubai: If you’re struggling to find a way to earn more interest-related growth or profits on the savings stashed in your bank account, particularly in an ultra-low interest rate environment, bankers are flagging how a key finance fact is often misunderstood when it comes to gauging savings growth.
The overlooked concept is that of ‘average returns’. If you understand how averaging works, you can see how your return over many years may be much different from the rate you are currently getting on your savings. Let’s delve into this understanding deeper.
“Right now, most savers worldwide are lucky if they can find a savings account with over 1 per cent return. But even if returns are paltry now, this doesn’t mean your average rate over time will be near as low as the returns you're getting right now,” said Anil Pillai, a Dubai-based banking analyst.
“What’s always key for savers is to not worry so much about what the current interest rate is right now, but instead prioritise setting up a habit of saving consistently and keeping that money parked in the account, and longer the money stays there, the better.”
How does interest rates work on your savings accounts?
‘Interest’ on money is commonly defined as the cost of borrowing money. Generally, you’ll pay interest to borrow money, and you can collect interest when you lend money. But who’s going to pay you to borrow your money?
For many people, opening a savings account is one of the easiest ways to go about this. When you put money in a savings account, the bank is technically borrowing the money and paying you interest in return.
So essentially, an interest rate determines how much money a bank pays you to keep your funds on deposit. However, Jose Paul, an Abu Dhabi-based banker with over two decades in the field, stressed on how you should use the annual percentage yield (APY) to compare your savings accounts.
“While the bank determines the savings rate, it’s often thought to be indirectly affected by the level of rates in the economy and whether the bank looks to attract new deposits. A better way to look at savings rate would be to look at the APY – it’s what you truly get on your money,” Paul explained.
Use APY to know how much you’ll truly earn on savings
“What this means is you can use the APY to determine how much you’ll actually earn in interest each year because the APY relies on two inputs: the interest rate and also, more importantly, on how often the interest compounds. Both contribute to how interest works on a savings account.”
This is because these two factors will impact how much money you’ll earn over time. Your savings account interest could compound daily, monthly, quarterly, or annually. Let’s look at an real-life example, and assume you deposit Dh5,000 into a savings account.
Assuming you don’t deposit or withdraw any more money, and the interest rate doesn’t change, if the account has a 1 per cent interest rate and the interest ‘compounds’ annually, i.e. what the bank pays you interest on your balance once each year, you’ll earn Dh50 after the first year.
The APY will then also be 1 per cent in this example because your interest didn’t compound multiple times during the year. Lucky for savers, many banks worldwide offer savings accounts with interest that compounds daily or monthly, rather than annually.
What type of savings account do you ask for at your bank?
“Even if a bank offers 1 per cent interest rate on a savings account, it helps to have an account with interest that compounds daily or monthly, rather than annually. This is how the rate of compounding could affect the APY and your earnings, although the differences may be minor,” added Pillai.
“When interest rates are low, there isn’t a huge difference on smaller balances. However, your earnings can increase over time, especially when the savings account offers a higher interest rate and APY, and you’re regularly depositing money into your account.”
Pillai also suggested that while you may prefer a traditional savings account if you want to bank in person, for better interest rates and lower fees, you might like an savings account with online-only banks, also referred to as ‘neobanks’, which offer comparatively higher yields.
“But when looking for a suitable savings account, keep in mind interest rates are always variable, not fixed and that inflation might erode the value of your savings. Also, some banks require a minimum balance to earn higher interest, and some accounts might charge fees for doing so.”
Savings account isn’t the only place for long-term growth
When debating avenues to grow your earnings, while it’s beneficial to look beyond just the interest rates offered on your savings account, experts reiterate that your savings should not be only parked in your bank account, especially when you are looking to grow your savings for the long-term.
“While a savings account is a must in case short-term financial needs arise, larger amounts of cash should be invested. If you’re looking to maximise returns, a savings account isn’t the best place to park any funds you don’t need to withdraw in the near future,” reiterated Paul.
“If you save and invest consistently over time, you will be able to maximise returns and minimise risk. So, just as past performance doesn’t indicate future returns, current returns don’t dictate your average return over time. Remember that when it comes to money, time is the most vital factor.”
The bottom line is while returns may be poor now, based on knowing now that interest rates are not the only go-to measure for earnings, if you stay the course, you are likely to get a chance to make up for those low returns down the road when calculating ‘average returns’.