Mary Holm: Low-interest argument has merit

Money in and of itself is useless. It's what you can buy with it that matters. Photo / File

I think you said recently that retired people preferred high interest rates because their money on deposit brought them more income. That can be true, but higher interest rates are usually linked to higher inflation, and I think even relatively savvy people ignore the decrease of their capital's purchasing power due to inflation, not to mention tax.

My pet hobby horse is that I think when people are doing their budgeting, there should be more emphasis by comparison websites on the effective interest rate you are receiving once tax and inflation are taken into account. And this can mean that an investor may be much better off in a low-interest scenario similar to what we have at present.

For example, at the moment if inflation is 1 per cent and a decent interest rate is 4.5 per cent, then with a tax rate of 33 per cent, 2 per cent is available for spending, with the post-tax remaining 1 per cent needing to be added to the capital to preserve its purchasing power. Whereas with inflation at 5 per cent, a seemingly attractive interest rate of 9 per cent would only generate 1 per cent for spending, with the post-tax remaining 5 per cent being necessary to preserve purchasing power.

I remember times when inflation was close to 20 per cent, and I was always very concerned that even a bank interest rate of 25 per cent would see my capital erode in value!

The point I made recently was a different one. Media commentators - probably with mortgages - sometimes suggest rising interest rates are bad. They are inclined to overlook the smiles on the faces of retired people and other savers.

But yes, you're right that it's really important to consider not raw interest rates but how they compare with inflation. As our mothers told us, appearances can deceive.

Looking back at the time of high interest rates and high inflation, it was actually worse than you depict.

For most of the late 1960s through to the early 1980s, interest on six-month term deposits was below inflation. Interest rose through that period from around 4 per cent to around 14 per cent - which must have seemed great for savers - but inflation was rising from about 6-18 per cent.

This is not just some theoretical point. Money in and of itself is useless. It's what you can buy with it that matters.

And in the early 80s, if you put $100 in the bank at the start of a year, sure, interest turned it into $114 by year-end. But because of inflation you could buy less with your $114 than you could have bought with the $100 at the start. And then - to add income tax to injury - you were taxed on the $14 of interest.

I agree with your hobby horse. It would be good to see more financial calculators using after-inflation numbers.

Over the years, many wise people have made a plea for taxing us only on the "real" interest we receive, after taking inflation into account. But that would cut government tax revenue, and would probably therefore lead to a rise in overall tax rates. Naturally that has little appeal to any government.

In the meantime, you're quite right that we're better off in a low-interest and low-inflation environment than when both numbers are high.

For anyone who had trouble following your numerical examples, this might help:

Low inflation and interest. After 33 per cent tax on interest of 4.5 per cent, you're left with 3 per cent. Inflation is 1 per cent, so you add 1 per cent to your savings so you don't lose buying power. That leaves 2 per cent to spend.

Higher inflation and interest. After 33 per cent tax on interest of 9 per cent you're left with 6 per cent. Inflation is 5 per cent, so you add that to your savings so you don't lose buying power. That leaves just 1 per cent to spend.

Conclusion: In these scenarios you're better off with 4.5 per cent interest than 9 per cent interest.

Oh, and I agree with your hobby horse. It would be good to see more financial calculators using after-inflation numbers.

Increasing nest egg

The monetary situation of my wife and I must be typical of thousands of conservative retirees.

We are in our mid-70s and are alarmed at the continual downward track of returns on term deposits.

We are debt-free, have no mortgage and have $750,000 in savings in various banks. While continuing to be conservative, there must be other methods of increasing our nest egg beyond the 3 to 4 per cent we are currently getting from the banks.

You're probably just the sort of people the previous correspondent had in mind. If you think about his main point - that it's not the basic interest rate that matters but how it compares with inflation - things aren't too bad right now. Inflation is currently a paltry 0.1 per cent, making your real (inflation-adjusted) interest pretty healthy.

There are those who say inflation is different for retired people, because they buy different things. Some have even suggested the government should calculate a consumer price index for the elderly, to be used when they adjust NZ Super each year. But I'm sure such an index would also be low these days.

Still, you would like to earn a bit more on at least some of your savings. The trouble is that anything that earns more than bank term deposits will be at least a bit riskier.

Your best bet is probably a low-to-medium-risk managed fund, which typically holds high-quality corporate bonds plus some cash, some shares and perhaps some property.

Returns will fluctuate, with some years better than others, and in a medium-risk fund there may be an occasional annual loss. But average returns should be higher than bank term deposits. And because the funds are widely diversified, and supervised by separate companies, it's hard to imagine you would suffer a loss over more than a short period.

An easy way to learn what's available is to use the KiwiSaver Fund Finder on www.sorted.org.nz. Work through its "Find the right type of fund for you" tool to decide what risk level is suitable, and then find a KiwiSaver fund that would suit you if you were able to join.

Then go to the provider's website and ask if they have a similar non-KiwiSaver fund. Most do. Check that you will be able to access your money whenever you want to. Then perhaps put a fairly small portion of your savings there to start with, and see how it sits with you.

KiwiSaver fees

I noticed a question posed in your column about fees eating away at small balances. It was a good point and one we at Grosvenor KiwiSaver have considered ourselves.

After the removal of the $1000 kick-start we made some changes to our KiwiSaver fees to help make things a little easier. We waive the member fee for those whose balances are $500 or less, and this applies regardless of whether they have a low balance because they've just joined, or because they've made withdrawals.

That's a great idea. After all, most people's balances don't stay small. Let's hear from any other providers who have done something similar.

Fixed or floating?

We will shortly take possession of our first home. We are 23-year-old university graduates from Auckland who live and work in the Far North. Thankfully we have had KiwiSaver for over five years and have worked part-time since high school, building our deposit to around $35,000. We have bought our wee two-bedroom home for $110,000.

Because our mortgage will be relatively small at about $75,000, we are unsure how best to pay it off in a five to seven-year time frame.

We have a bit of mortgage flexibility, due to our deposit being over 20 per cent. To fix or to float? Does it matter with such a small mortgage?

This process has been a huge step and learning curve for us both, but thankfully our financial risk is tiny compared to other first-home buyers in other parts of New Zealand. Regardless, we want our mortgage paid as fast as possible with as minimal interest as possible. Any tips would be great.

Well done on several counts: working and saving since high school; making the most of the KiwiSaver first-home help; starting with a modest house to keep your debt down; and planning to pay off that debt in short order. As you say, this is easier to do in the Far North, but still.

Even with mortgages at current low rates, most people pay a huge amount of interest. With a 5 per cent 30-year mortgage you repay nearly twice as much as the loan. The longer the loan and the higher the interest rate, the worse it is.

The mortgage repayment calculator on www.sorted.org.nz shows this. It also helps you work out how much less interest you will pay if you increase your payments.

And - just as in today's first Q&A - this is not some theoretical point, but real money. The several hundreds of thousands of dollars some are paying in mortgage interest is all money they could be doing something else with.

So, on to your question about fixing versus floating. Currently floating mortgage rates average 5.8 per cent, according to CANSTAR. Average fixed rates start at 4.6 per cent for one year, and gradually rise to 5.3 per cent for five years.

At first glance, fixed clearly looks better. But whenever floating rates are higher, that suggests the experts expect rates to fall in the near future. You pay a premium now but chances are good that your rate will go down.

Having said that, it's hard to imagine the rate dropping so much below 4.6 per cent within a year that you would be glad, a year from now, that you chose floating over one-year fixed.

The point is more valid, though, if we look at five years. It's quite possible that, if you took a five-year fixed mortgage at 5.3 per cent, within that period rates would drop to the point where you wish you had gone with a floating rate.

But who knows? Maybe in five years rates will be considerably higher rather than lower, and you would be thrilled with your 5.3 per cent fixed.

Usually I suggest a bit of both fixed and floating.

At the end of the fixed period you will either be glad you had some floating because rates have fallen, or glad you had some fixed because rates have risen! Also, you can't usually pay a lump sum off a fixed loan without penalty. And you never know when you might receive an inheritance, redundancy pay or a lottery win, which you can use to repay the floating loan.

But in the current market, I'd be tempted to grab a one-year fixed loan and review the situation in a year's time. If you do receive an unexpected lump sum, you can always hold it in a bank term deposit. For less than a year, that's no big deal.

Mary Holm is a freelance journalist, member of the Financial Markets Authority board, seminar presenter and bestselling author on personal finance. Her website is www.maryholm.com. Her opinions are personal, and do not reflect the position of any organisation in which she holds office. Mary's advice is of a general nature, and she is not responsible for any loss that any reader may suffer from following it. Send questions to mary@maryholm.com or Money Column, Business Herald, PO Box 32, Auckland. Letters should not exceed 200 words. We won't publish your name. Please provide a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice.

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