How to make high inflation work for you

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• Published: 26 Jul 2010 in Money and Savings

By Stephen Jones

Ask a saver what word they hate the most and they will likely tell you straight away - 'inflation'. That’s why the recent withdrawal of NS&I’s inflation-busting savings products was such bad news for consumers who have already been struggling to get any real return on their savings.

The Retail Prices Index (RPI) – a measure of inflation that includes housing costs such as mortgages and council tax – hit 5 per cent at the last count. To beat this, a basic-rate taxpayer would have to find an account offering 6.25 per cent – rare indeed in the current climate.

With the Bank of England unwilling to raise the base rate in a continually unstable economy, and nervy banks still reluctant to seriously compete, NS&I’s index-linked savings certificates offered consumers a rare opportunity to make real gains on their cash by guaranteeing to beat inflation.

Making savings work

Nick Scarrett, head of pensions and investments at Fair Investment Company, says it is not currently clear whether the spending-conscious government will allow the products to return while inflation remains above target of 2 per cent. Until they do, he warns that savers will have to be a little savvier to battle against a period of “unchecked inflation”. So what options are available?

“There are currently some income-producing structured products offering annual incomes of up to 7.5 per cent and annual kick out plans with returns up to 12 per cent,” he says. “Investors can also purchase government inflation-linked bonds through a stockbroker, or access them through a collective fund.”

For lower-rate taxpayers, tax-free cash ISAs should really be the first place you look. Of those around, the Royal Deposit Plan ISA from RBS offers 3.50 per cent with a 3 year fixed rate, while the Investec Investec 5 year FTSE Deposit Plan will also give 4.5 per cent annually provided the FTSE 100 Index remains at or above 50 per cent of its initial level. The capital invested in the latter will still be returned in full at maturity, regardless of the performance of the FTSE 100 Index, so could be a great investment if you’re willing to lock your money away for a good while.

Sadly, there are currently few inflation-beating options in traditional savings and bonds for those paying tax on the higher rate, although taking a look at income plans may produce some good opportunities. Morgan Stanley’s FTSE Income Plan, for example, offers 7.50 per cent annually regardless of the performance of the stock market index (again, as long as it remains at half of more its original level).

Using inflation to your advantage

One group that will be pleased to see inflation remain high is borrowers. As the cost of goods rises, now may well be the time to forget saving and simply pay off your borrowing while rates are low.

Matthew Lloyd, Confused.com’s head of life insurance and mortgages, offers the following rule of thumb: “If your mortgage rate is higher than the after-tax savings interest, don’t save, overpay the mortgage.

“As always, there is a caveat to that,” he adds. “You should, where possible, make sure you have an emergency fund. As a guide, use a minimum target of three times your net monthly income before you even consider overpaying any debt.”

For borrowers, it is also worth thinking about the following:

- Check when your mortgage company recalculates the interest due. With monthly, and especially annually, calculated mortgages, it’s vital you time any extra repayments correctly as money put towards the mortgage only counts after the calculation is made; so putting your money in too early won't have any impact and you'll miss out on interest you could’ve earned in a savings account.

- If you have an interest-only mortgage make sure any extra payments you make specifically go towards reducing the capital, in other words decreasing the actual debt. This will mean you attract less interest. 

- If you have a high loan-to-value (LTV) mortgage, it might be worth overpaying even if you can get a more attractive after-tax savings rate. This will effectively reduce your LTV and potentially get you access to more competitive mortgage deals, which could work out to be far more beneficial in the long run.

For more tips and useful information, take a look through our Guide to choosing the right mortgage and our recent Mortgage Monitor round-up. Once you’re ready, why not compare mortgages to see what’s on offer? 

All rates correct on 26 July 2010