There is no question that interest rates favor borrowers, not savers in our current economic climate. When I talk about saving, I mean extremely low risk options for storing money like a savings account or guaranteed investment certificates (CDs) with 0.10% – 1.50% interest rates. At these rates your purchasing power is lower once you account for inflation, devaluing your money over time.
Then I got to thinking, would a saver be better off financially in the 80’s and 90’s when interest rates on GICs were in the high single and low double digit figures (5%-12%). Compared to savers in the early to mid-2000 when rates were in the low single digit figures.
So I decided to do a comparison. In my analysis I looked at two time periods in Canada between 1985 to 1995 and 2005 to 2015. After accounting for inflation and taxes, when would a low risk saver most benefit from putting their money in GIC’s?
Before getting into the details and calculations, here are some assumptions I made:
- The individual lives in Canada. All rates are based on the Canadian economy.
- Since they live in Canada they cannot deduct any of the mortgage expense from their personal residence on their tax return.
- GICs earn interest income, which is fully taxable at the individual’s tax bracket.
- Federal tax rate is 20%. Provincial tax rates are not included as they vary too much across the provinces.
- I used an average instead of cherry picking any specific year when doing my analysis to smooth out the data, but the analysis is based on a one-year time period. So, if someone held a GIC at any year between the timelines outlined above, they can expect to receive a value based on the average. This avoids picking very low or high rates at any given year.
- The averages were determined for the rates & timelines below
|5 Year GIC Interest Rate||9.05%||2.30%|
|Federal tax rate||20%||20%|
- To convert nominal rate of return to real rate of return, this was the formula I used:
Analysis: 1985 to 1995
Between 1985 to 1995, an individual could receive a return of 9.05%. This is the nominal rate of return. However, because of inflation this value has to be reduced to account for the loss in purchasing power that inflation causes. So adjusted for inflation the real rate of return is actually 5.45%. The income earned from a GIC is interest income, and interest income is fully taxable. The federal tax rate of 20% will eat into this money, leaving 4.36% in real rate of return (after taxes). Calculation layout below:
|Average values between 1985- 1995||Percentages|
|Avg. 5- Year GIC interest rate (Nominal return)||9.05%|
|Avg. inflation rate (3.41%)||(3.60%)|
|Real rate of return before taxes (adjusted for inflation)||5.45%|
|Federal tax rate (@ 20%)||(1.09%)|
|Real rate of return (after taxes)||4.36%|
Analysis: 2005 to 2015
Similar concept as above. After adjusting for inflation and taxes a 0.44% real rate of return would be realized from a 2.30% nominal return. Calculation layout below:
|Average values between 2005- 2015||Percentages|
|Avg. 5- Year GIC interest rate (Nominal return)||2.30%|
|Avg. inflation rate (1.74%)||(1.75%)|
|Real rate of return before taxes (adjusted for inflation)||0.55%|
|Federal tax rate (@ 20%)||(0.11%)|
|Real rate of return (after taxes)||0.44 %|
The numbers speak for themselves, low risk savers in the 80’s and 90’s enjoyed a better rate of return even after accounting for inflation and taxes than those in 2000s. But did they really get to enjoy these savings? To answer that, I looked at housing costs?
The biggest expense that most households have is their housing costs, notably mortgage payments. Since home ownership has and probably always will make up a large portion of a family’s asset portfolio, it makes sense to include the cost associated with owning a home, mortgage interest rates. Other reasons for including the mortgage interest rate for cost are:
- The rate of Canadians who own a home has been steadily increasing. In 2016, 70% of Canadians owned a home.
- Most Canadians do not live in a mortgage free home.
- Paying down the principal on a mortgage builds equity over time, but the interest expense on a mortgage (like any other debt) is a sunk cost that does not increase net worth.
In keeping with the same timelines, the average interest rate on a 5-year mortgage is as follows:
|5 Year Mortgage Rate||10.85%||4.99%|
So, if we subtract the mortgage interest rate (our biggest cost of borrowing) from the real rate of return, the perspective changes a bit.
= Real rate of return (after taxes) – Mortgage interest rate
= 4.36% – 10.85%
= (6.49%) loss
= Real rate of return (after taxes) – (Mortgage Interest Rate)
= 0.44% – 4.99%
= (4.55%) loss
In both instances there was a loss, but those saving in 2005-2015 are now benefiting more than their counterparts in the 80’s and 90’s. The overall take away I got from this was that:
- It was more costly to own a home and save in the 80’s and 90’s then in 2000’s (assuming you still have a mortgage).
- Cost of borrowing plays a big part of the equation. Whether it is borrowing for a home (mortgage interest rates) or a credit card, it can affect your net worth in the long run, even if interest rates on savings accounts are high.
- Where you save your money affects how much of a return you will realize after inflation and taxes. Safe investments like GIC’s and bonds are fully taxable, which reduces your realized net worth.
- Inflation and interest rates (both interest earned and interest paid) affect rate of return.
- If you own a home and pay a mortgage, but are a low risk saver (heavy in GICs), you may still be better off financially then in the 80’s and 90’s.