Cash ISAs can be a great tool to save for the future. Any interest earned on money invested in these wrappers is not liable for any further tax, which makes them particularly attractive for higher rate taxpayers, who have to pay an additional tax rate on interest earned over a set level.
However, interest rates available on Cash ISAs have been dropping steadily over the past 10 years. They’ve now fallen to such a low level that most savers would be better off avoiding them altogether.
A low-interest rate
The best easy-access Cash ISA on the market at the moment offers an interest rate of just 1.35%. If you are willing to lock your money up for a year, you can earn a bit more interest, but not much.
The best one-year fixed ISA rate is 1.41%, and the best two-year fixed ISA rate is 1.55%. The best five-year rate is 2.03% at the time of writing, from UBL UK.
The problem is, none of these rates match the current rate of inflation. Consumer price inflation averaged 2.5% in 2018 and it looks as if it’s going to be above 2% for 2019.
Between 1989 and 2019, the annual rate of inflation across the United Kingdom averaged 2.6%, which implies that if you lock your money up for five years at an interest rate of 2.03%, it will lose around 0.57% of its purchasing power every year.
A better investment
A loss of purchasing power of 0.6% every year might not seem like much, but in theory, it would make more sense to spend your money at this rate of return rather than save it and watch its value deteriorate.
That’s why I think owning a Cash ISA could be the biggest investing misstep you could make in 2020.
A better buy
Instead of owning a Cash ISA, I would open a Stocks and Shares ISA instead.
You see, over the past 100 years, UK equities have produced an average return for investors in the region of 5% after taking inflation into account. Over the past 20 years, the FTSE 250 has produced an average annual return for investors of around 11%, or 9.4% after taking inflation into account.
Stocks and shares are a much better way to protect your wealth against inflation because rising prices drive inflation. As companies increase their prices, earnings should grow at a similar rate, which will drive share price growth.
The bottom line
If you are serious about saving for the future, an investment in the FTSE 250 will help you reach your savings goals much faster than a Cash ISA.
According to my calculations, £1,000 invested in a Cash ISA at an interest rate of 2.03% would grow to be worth just £1,224 after 10 years.
The same £1,000 invested in the FTSE 250 growing at a rate of 11% per year, would be worth nearly £3,000 after a decade.
These numbers don’t take inflation into account, but I think they clearly show why owning a Cash ISA in 2020 could be detrimental to your wealth over the long term.