Options for savers have been limited for a long time now. With interest rates still at a record low, savers are mostly limited to fixed-rate products or riskier peer-to-peer options if they want to make any decent returns on their savings.
The two types of standard savings account that stand out from the rest are fixed-term bonds and Individual Savings Accounts (ISAs). Although these are similar in some respects, there are pros and cons to each that need to be evaluated before making a choice between the two.
Let’s start with fixed-rate bonds.
Fixed-rate bonds (or fixed-term bonds) provide a fixed rate of return for the duration of the term. This gives you a guaranteed rate of income for a set period with no surprises.
Rates on these accounts can differ, but as a general rule: the longer you decide to lock away their funds, the better rates you’ll get. This is because it benefits the banks to have control of your cash for longer.
While ISAs have an annual deposit limit, fixed-rate bonds allow you to make huge deposits. Some bonds have very high maximum limits (or no limits at all), allowing you to save as much as you like, while some bonds have quite a high minimum deposit in order to qualify for higher interest rates.
Something to remember is that you won’t be able to add to the bond once it’s open. (This goes for fixed-rate ISA products as well.) However, unlike ISAs, there are no limits as to how many of these accounts you can open within any one year, so there is nothing stopping you from opening five separate accounts across different banks.
This is important because of the way that UK savings are protected. UK savers are only protected for up to £85,000 per person per banking license. If you have a large sum to deposit and you’re looking for maximum protection, it may be worth opening a number of bonds across different institutions to be on the safe side. (Find out more in our guide to Secure Savings.)
A fixed-rate bond is a bit of a calculated gamble. The rate is not affected by the Bank of England base rate, so it could potentially go one of two ways. If the base rate falls and other savings accounts fall with it, your rate is guaranteed, and you’ll be benefitting from your decision to lock your funds away. Equally, if the base rate rises, and savings rates get better, there’s a risk that the rate you lock into will become uncompetitive.
It’s for this reason that experts tend to recommend that you don’t lock away your funds for a long time without a great deal of consideration. It’s not just about luck – you can often get an insight into base rate predictions – but things can happen that you’ll never foresee. But remember to do your homework, as you could find that rates begin to rise and suddenly the rate on your bond is a lot less attractive.
It’s not just about the rate, either. You need to make sure that you choose a term that is right for you and that you can manage without your cash for this period. Early access to your cash is not normally permitted, and if you have to close the bond, you’ll forfeit some (if not all) of your interest.
As with any normal savings account, the interest you earn counts as income, so is subject to tax. For anyone on the lower tax band (under £31,865) the tax rate is 20%. For those earning above this rate must pay 40%. There are other circumstances in which non-earners may be given a tax free allowance, so check out the HM Revenue website for more information.
The tax element is important because the returns offered by bonds will become less competitive after tax. A long-term fixed-rate bond may become less competitive than a fixed-rate ISA once tax has been accounted for.
Next, let’s look at Individual Savings Accounts.
Individual Savings Accounts
Individual Savings Accounts (or ISAs) offer a tax free option for savers. The difference between ISAs and your average savings account (including fixed-rate bonds) is that you don’t have to pay any tax on the interest you earn.
With ISAs, the rate you see is the rate you actually get. Even if the rates on ISA accounts appear lower than fixed-rate bonds, the returns may be better once tax has been deducted.
Each year, you’re given an allowance that you can put into your ISA (currently £15,000). This allowance is renewed every April, but you cannot carry any leftover allowance forward, so it’s worth making the most of this each year.
ISAs are available in a range of options to suit your needs, including fixed-rate, base rate guarantee, and easy access. Unlike fixed-rate bonds, most ISAs can be topped up as often as you like, up to the maximum limit. Investing the full limit into your account as soon as your allowance renews allows you to benefit the most from the tax-free interest. If this does not suit your savings plan, you could save every month instead.
Easy access ISA are normally variable rate accounts, which means that the rates could change. Some of these accounts come with a temporary bonus rate that lasts for about a year, after which the rate normally plummets. (See Savings & Bonus Rates for recommendations on how to avoid the traps.)
Locking your funds into a fixed-rate ISA offers the same guarantees as a fixed-rate bond – and the returns will still be tax free. But it comes with the same risks identified with fixed-rate bonds as well.
The Bottom Line
Both types of accounts have clear benefits for savers as they encourage you to leave your money to grow over time. With any savings account, it’s always practical to make sure you’re gaining the highest possible returns. Although ISAs provide tax free interest, you could find that the difference in rates offered when comparing to fixed-term bonds will in fact leave you worse off. Before you decide, compare the savings market to give you an idea of what’s available.
It’s also important to make sure your account is paying a higher interest rate that the rate of inflation. Anything below this means that your deposits are losing value in real terms. If prices are rising at a higher rate than your savings are earning, the account is not providing enough.
Finally, always make sure that your savings are safe. With the recent financial crisis, many financial institutions have been feeling the pinch. And although it’s unlikely that your bank will collapse, it’s something to be aware of.
For more information on which banks carry which schemes, and which banks fall under the same license with the compensation scheme, you can find the full details on Which4U’s Savings Accounts page.