Living within your means and investing in a Cash ISA may seem like a good idea. After all, you would be building up your capital and not taking any risk of loss in doing so.
However, the appeal of a Cash ISA has declined in recent years. This is partly due to tax changes, with a bog-standard savings account now being just as effective at building up a cash balance for most people.
In addition, with interest rates set to remain low and inflation forecast to remain at its current level, there is a risk that the returns on a Cash ISA will lead to reduced spending power over the long run.
Tax changes
The first £1,000 of interest income you receive each year is tax-free anyway. This means that unless you obtain more than that amount from your cash savings, there is little point in having a Cash ISA.
For example, if you have £50,000 in a bog-standard savings account earning 1.5% in interest each year, you would not pay any income tax on the £750 interest received. The total amount of interest received is below the £1,000 threshold, thereby making a Cash ISA no different from a savings account in that example.
In fact, you must have around £67,000 in a savings account generating 1.5% in interest before a Cash ISA starts to offer tax savings. Since few people have such a large amount of cash, there seems to be little to gain in using up your annual ISA allowance on contributions to a Cash ISA.
Interest rate forecasts
Clearly, interest rates are likely to rise in the long run. They have never remained at a low level in perpetuity, so the returns on a Cash ISA could improve over the coming years.
However, their pace of growth could be slower than many savers are anticipating. The uncertain future for the UK economy during what may prove to be an extended period of Brexit negotiations and transition may lead to a cautious stance on monetary policy from the Bank of England. This may mean that the ‘normal’ interest rates of 4%+ from prior to the global financial crisis over a decade ago may not return for several years.
Inflation risks
While a Cash ISA will not produce a loss of your capital, in real terms it can be a highly disappointing place to invest. Inflation is forecast to remain at around 2% over the medium term, which means that the current Cash ISA interest rates of approximately 1.5% may lead to reduced spending power.
Certainly, this may not be noticeable over a short period. But when cash is held over the long run, it can lead to a disappointing financial outlook when compared to other faster-growing assets such as shares.
Therefore, having some cash may be a sound idea in case of emergency. But focusing your capital on a Cash ISA, rather than the stock market for example, could prove to be an unwise move.