Chasing the Highest Interest Rates on Savings – Is it always a good idea?

Chasing the highest interest rates on savings accounts can be a worthwhile and profitable activity, especially for home deposit savers and retirees looking to maintain and improve their standard of living in a world of ever increasing living costs. But there are considerable pitfalls and risks for the unwary.

If you’ve ever surveyed the market, you’ll have noticed that the less well-known institutions typically offer higher interest rates on savings accounts. Why do they do that? Often, it’s simply a case of having to do so to attract customers.

Market Dominance

That’s because the major banks in Australia, the Commonwealth, Westpac, ANZ and the National, have enormous customer bases, strong brand recognition, extensive branch networks and many sources of funding. This market dominance is sometimes referred to as an oligopoly, although the banks regularly claim that there is extensive competition in the marketplace.

As a consequence of their dominant market position, the larger banks do not need to pay the highest interest rates on deposits/savings accounts to attract depositors. That’s because millions of people leave money with them out of convenience, trust in their financial strength or simply fail to act out of inertia. And there’s another factor. Some people have so many products and services tied up with their bank (e.g., credit cards, car loans, term deposits and mortgages) that moving money and opening accounts elsewhere becomes too hard (it isn’t necessarily, but it’s often seen to be so).

Using a Savings Calculator

Some people might say that earning an extra 0.25%-0.5%pa on your personal savings (especially after tax) isn’t worth the trouble of doing the research and going through the bureaucratic process of changing to another institution. That’s an understandable reaction, but before you decide, use the MoneySmart savings goal calculator. You may be pleasantly surprised how much difference a small percentage increase makes to your savings over time (the longer the better due to the magic of compound interest).

Researching the Market

Of course, this assumes you’re up for doing the research. There are many comparison sites that can be useful, but be aware that some of them have commercial arrangements with financial institutions that might skew your conclusions. In addition, the Australian Consumers Association (Choice) does regular independent surveys of the savings account marketplace. So while the available information is plentiful, it’s a case of your interest in exploring it. We hope that you might now be motivated to do so!

Deposit Guarantees

People often hesitate to take advantage of higher interest rates or accounts with better features because they are offered by financial institutions with which they’re not familiar. That’s understandable, but it’s important to acknowledge that most banks, building societies, credit unions, and on-line financial institutions in Australia are so-called authorised deposit-taking institutions (ADIs).

This means they are covered by the Financial Claims Scheme (FCS) under which the Australian Government guarantees deposits held by individuals with an ADI in Australia, up to $250,000 per person, per ADI. You can find a description of the FCS and a complete list of ADIs on the Australian Prudential Regulatory Authority (APRA) website.

Non-Bank Institutions

Beyond the world of ADIs, there are other organisations that offer to pay interest rates well above what we might call “normal” rates on savings accounts. For example, in recent months we’ve seen promotional material offering “regular income of up to 10.5% pa” from products called real estate credit funds.

Typically, these are investment vehicles that pool capital from investors to provide loans to property developers and commercial owners, rather than buying physical property. The idea is that investors earn regular income derived from loan interest, with investments typically secured by mortgages and agreed loan-to-value (LVR) ratio/limits.

Assessing the Risk

What should potential investors make of these offerings? The first (and most important) point to note is that these products are riskier than putting your money in an ADI/bank. The higher interest rate on offer is the clue to that fact.

Putting it another way, the advertised returns of roughly 10%-17% on some offerings are much higher than bank deposit rates because investors are taking additional risks, sometimes substantial ones, even though they might not always be aware of it (naturally, promoters aren’t going to emphasise risks when placing your savings with them!).

Key Risk Factors

Many of these products involve lending against residential or commercial development projects. The higher interest rates compensate investors for risks, such as:

Developer default risk

where a developer cannot complete a project or repay a loan

Property market risk

where falling property values reduce the value of the security backing the loans

Construction risk

caused by cost overruns (especially on a fixed price contract), delays, builder insolvency, planning issues

Liquidity risk

Unlike a bank account, you may not be able to access your money when you need it. Some of these products have fixed terms and limited withdrawal windows

Valuation risk

Unlisted property funds don’t have daily market pricing, making the true value harder to assess. This can hide volatility that would otherwise be visible in listed (stock exchange) investments.

That these high return/interest products are secured by mortgages helps with risk considerably, but it does not make them as “safe as a bank”, thereby substantially explaining the interest differential between the two kinds of products.

Questions to Ask

All of this doesn’t mean you should automatically steer away from investing your savings in these offerings. However, before you do, we recommend that you understand how these products are structured and the risks involved.

Consider asking these questions:

• Is the fund investing in first or second mortgages (or maybe even third mortgages)?
• What is the average LVR (loan to value ratio/limit)?
• What happens if a borrower defaults?
• How often can investors withdraw?
• Has the fund ever suspended withdrawals?
• What are the management and performance fees?
• Can I read the Product Disclosure Statement/Information Memorandum?

Seeking Advice

If having done your homework and research, you are still undecided about whether to invest your hard earned savings in a higher interest rate (non-ADI) product, perhaps your answer is not to do it at all, or at least to seek independent professional financial advice before you decide, noting that advice can be costly, but could save you from a decision you’ll live to regret.