Admittedly, it’s not one of the easiest (or most exciting) subjects to understand. However, with the amount of airtime that inflation is receiving in the media, now is as good a time as any to get informed.
According to figures from The Organisation for Economic Cooperation and Development (OECD), less than two fifths of UK adults understand inflation, and how it affects their finances.
In order to grasp the subject without getting too deflated, a good starting point is to look at the seemingly magical effect of compound interest.
“The most powerful force in the universe is compound interest”
When Albert Einstein said this, he’d already developed the theory of relativity, tucked a Nobel Prize under his belt and seen plenty of the forces that the universe has to offer.
And he wasn’t wrong. Compound interest is the accumulated interest from previous periods of time plus the initial sum saved. Interest is calculated on the total amount accumulated, rather than just the amount deposited; including any prior interest.
As a simple example, if you deposit £100 into an account which offers compound interest at 2% annually:
- Year one will return 2% of £100 for a total of £102
- The second year will return 2% of the current total of £102, making the new total £104.04
- Year three will return 2% of 104.04, leaving a new balance of £106.12
Naturally, this is the case when no withdrawals or deposits are made in between. The main benefit can be seen clearly, however, in that you gain interest on your interest, rather than just on your deposited capital.
Inflation is the rate that the price of goods and services rises year-on-year. Inflation is also compounded; however, it is the real terms loss that compounds, giving you reduced buying power.
Inflation can be calculated in many ways. A common way is using the Consumer Price Index (CPI). Every month, the prices of thousands of products are collected and compared with the same data from 12 months earlier. The difference between the prices shows how much the cost of living has increased and is presented as a percentage.
Inflation is compound because every percentage is calculated using a figure which has already increased every year. Like compound interest, only the most recent figures are used to work out the difference.
This compound growth of the cost of living means that the value of any funds which are not seeing returns which match or exceed inflation will be eroded.
How can my money lose its value?
The rate of inflation as measured by the CPI is usually much higher than interest rates of savings accounts. This means that prices will grow faster than your savings account balance.
For example, imagine that you deposited £1,000 into a standard savings account with an interest rate of 0.25% in August 2016. In the same month, a new laptop cost £500, meaning that you could have purchased 2 laptops with your savings.
One year later, you would have £1,002.5 in your savings account. The rate of inflation in August 2017 was 2.9%, so a new laptop would now be worth £514.50. Because the rate of inflation was higher than your return rate, you can only buy one laptop, meaning that whilst your savings have increased, they are effectively worth less.
Why is financial literacy important?
The research from OECD shows that in the UK:
- 96% of adults are at least partly responsible for household financial decisions
- 84% of people claim to pay their bills on time
- 75% monitor their finances closely
- 69% consider their purchases before making any decisions
- Just 45% set long-term financial goals and strive to achieve them
In addition, the data shows that more than 70% of people are active savers, but without understanding how factors such as inflation and interest rates are affecting your buying power, it may be a futile effort.
Understanding how external factors affect your finances means that you can plan better for the future. By knowing how inflation will erode the value of your money, you can put a strategy in place to beat inflation, or maintain the value of your savings as much as possible.
The current situation and staying afloat
In December 2017, the CPI was 2.8%. With uncertainty ahead, how can you secure your finances and get ahead?
Information: Keep yourself up to date with financial news and developments and make sure to explore things deeper to educate yourself.
Shopping around: The best interest rates are unlikely to land in your lap. So, take the time to investigate the market to ensure that your money is in the best place.
Financial advice: Offering impartial advice, which is tailored to suit your circumstances, Independent Financial Advisers are the best port of call for all issues finance related.
To discuss how inflation is affecting your financial future, contact Sarah or Bev on 0115 9338433.