1.4% from a cash ISA? I’m buying the FTSE 100’s yield of 4.3% instead

Cash ISAs are a great product in theory. They allow you to save £20,000 a year tax-free. In fact, you never need to declare interest from the savings on your tax return, which is a double bonus as it saves both money and time when filling in self-assessment tax forms.

However, for the past 10 years, the interest rates available on cash ISAs has been steadily declining. Today, the best rate you can get on an instant access cash ISA comes from Charter Savings Bank, which pays 1.4% per annum and has a minimum account balance of £1,000. If your balance drops below this level, the rate of interest resets to just 0.1%.

Higher rates are available if you are willing to lock your money up for longer. Charter offers 1.6% if you don’t touch your money for a year or 2.26% per annum if you are happy to lock your funds away for five years.

A waste of time

Personally, I believe these products are a waste of time. A tax-free interest rate of 2.26% might look attractive at first glance, but with the rate of inflation currently running at around 2.7%, this rate of return implies you are receiving a real rate of interest of -0.44%. To put it another way, if you sign up to this product the purchasing power of your money will decline by 0.44% every year it’s locked away.

So, instead of trawling the market for the best cash ISA rate, I have put my trust in the FTSE 100. Today, you can buy a low-cost tracker fund for the FTSE 100 for only a few basis points every year. For this charge, you don’t need to do any work yourself, and you will have an instantly diversified income portfolio.

At the time of writing, the FTSE 100 supports an average dividend yield of 4.3%. This rate of return is three times higher than the best cash ISA rate available on the market today.

Even better, you can own a FTSE 100 tracker inside a stocks and shares ISA, which means it benefits from the same favourable tax treatment as cash savings in a cash ISA.

Reduced risk

Some investors might be concerned that owning stocks rather than cash, comes with more risk.

I believe the numbers show that this is not correct. With its inflation-busting dividend yield, FTSE 100 investors should see the purchasing power of their money grow in the long run. Meanwhile, investors who rely on nothing more than a cash ISA really will see the purchasing power of their money decline every single year.

In other words, keeping your money in a cash ISA comes with more risk than investing it because its value is being eroded.

So overall, instead of making do with a low rate of return available on cash ISAs today, I think a better course of action for savers is to buy the FTSE 100 and hold it in a stocks and shares ISA. The returns are higher, and you still benefit from the same favourable tax treatment. What’s not to like?

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.