When investing for interest income, your rate of interest depends on numerous factors.
A Fin24 reader planning to invest his payout, and live off of the interest, wants to know how much the interest will amount to. He writes:
I am expecting a lump-sum payout of R500 000. I want to invest it so that I can earn interest on a monthly basis, which I plan to live on. How much will it amount to?
Lauren Davids, Senior Investment Consultant at 10X Investments, responds:
We are unable to give you a definitive answer without doing a full "financial needs" analysis to determine the option most suitable for your needs. Our answer below is, therefore, for information purposes only.
When investing for interest income, your rate of interest depends on numerous factors, the most important of which is the prevailing repo rate (the rate at which the SA Reserve Bank lends to commercial banks). This is the initial reference point used by banks and other financial institutions to set their own interest rates.
The rate you specifically qualify for is linked to this, but also depends on other factors, such as the amount of money being invested, the investment term, the risk rating of the provider, and whether the return is linked to the market performance of an underlying instrument.
More risk, more reward
As is the general rule when it comes to investing, the more risk you assume, the higher your potential reward. If you want immediate access to your money, you will receive a lower interest rate than if you agree to a fixed investment term, say one month, or one year, or even five years. In return for receiving a higher interest rate now, you assume the risk that inflation (interest rates) rises in future, or that you may need to access the money for an emergency and incur an early withdrawal penalty.
Money market funds (a type of collective scheme) usually offer higher returns than a bank deposit, but the return, or your capital, is not guaranteed (although the underlying risks are still quite low).
The repo rate almost halved last year (from 6.5% to 3.5%), which saw a corresponding reduction in interest rates offered by banks. You won’t receive much more than 3% pa rate on a one-month fixed deposit now. This, however, increases to as high as 8% pa if you agree to lock up your money for five years.
That would give you an income range of between R1 250 pm and R3 333 pm. If this were your only source of income, you would not be taxed on these amounts, otherwise, the first R23 800 of interest income is tax-free (R34 500 if you are over 65) as well as interest received from a tax-free savings account. Each bank publishes its current deposit interest rates online, so you can shop around for the best deal.
Money markets funds pay slightly higher rates (between 4.6% and 3.5% pa at present), converting to a monthly income of between R1 500 and R1 900. Here, you do have the option to withdraw your money at short notice, however.
A word of caution though: investing all your money into cash, and living off the interest presents its own risks, especially for investors with a long-term perspective. Cash is considered a low-risk investment because it provides an almost certain return over the contract period. The downside is that rewards are typically not great; savers are usually compensated only for inflation and a bit extra, plus a risk premium for the issues mentioned above.
Because cash offers such a low real (after-inflation) return, relying exclusively on interest from cash savings increases the risk that you begin eating into your capital. Also, interest rates change, so your income may fluctuate from year to year. Alternatively, if you lock in your interest rate for, say, five years, you run the risk that inflation increases and that your real (after-inflation) interest return becomes negative.
Purchasing power eroded by inflation
Even if that does not happen, living off interest income creates the illusion that the underlying capital is being preserved, when, in truth, the purchasing power of that money is being steadily eroded by inflation. The interest you receive will afford you less every year and you would eventually have to access the capital to preserve your lifestyle.
There is a way to mitigate all these risks: investing in an inflation-linked, guaranteed annuity. Such annuities pay a much higher return, depending on the annuity you choose. For example, if you are 60 years old, you could buy an annuity that pays as much as R4 500 pm, increasing at 5% pa, which, hopefully will be enough to cover annual inflation. Your main risk is that you can then no longer access your money for an emergency, and there is no inheritance for your heirs.
*Questions may be edited for brevity and clarity.