There are three main benchmarks for determining a fair interest rate:
- The underlying rate of inflation. Investors may reasonably expect an interest rate that at least keeps pace with inflation, so that their investment does not erode in value over the longer term. Currently, this would suggest a floor to interest rates of approximately 2%.
- Long-term rates of return on other asset classes. Investors in community shares should receive no more than they would do from other equivalent forms of investment. Long-term rates of return vary from 4% on government bonds and treasury bills to 8% or more on equities, reflecting the risks associated with these different asset classes. This would point to a ceiling of approximately 8% for interest rates.
- Alternative cost comparison. A society should not pay more for capital than it needs to, which suggests that community share investors should not receive more than the commercial cost of debt to the society. Currently societies are paying commercial interest rates of between 5% and 7% for medium to long-term debt.
Taken together, these benchmarks indicate that the maximum share interest rates should currently be within the range of 2% to 8%. Many societies have rules which set their maximum interest rate on share capital at 2% to 3% above the Bank of England bank rate (or equivalent). Other societies that do not have rules setting a maximum interest rate should use the above benchmarks as a basis for determining whether their interest rates are higher than necessary.
Apart from interest rates, there are a number of other matters to consider when determining a society’s policies on interest payments. Many societies credit interest payments to members’ share accounts rather than sending out interest payment cheques. This increases the amount of share capital in the society, and improves capital liquidity if the money is not tied up in fixed assets.
Interest on share capital is normally paid gross of personal income tax. It is the responsibility of members to inform HMRC of any interest on share capital paid to them or credited to their share account. This should be borne in mind by societies when devising schemes to allow members the option of waiving interest on share capital or donating it to a good cause. Even though the member does not receive the interest, they may still be liable for income tax on that payment.
A society with more than one class of share may pay different rates of interest, if doing so serves the aims of the society. For example, a society may issue a new class of share capital to finance a wholly-owned subsidiary, with all the risk borne by this new capital. In order to attract this capital it may be necessary to offer a different interest rate from that applicable to other shares in the society.