Savings Bonds: How do they work?
By Kate Saines
If you are fed up with the lack of interest being paid on your instant access savings account, it could be time to compare savings bonds to find the best on the market.
The best savings bonds for people with small to medium nest-eggs are available as fixed-rate savings plans or inflation-linked products.
Whatever option you choose, with the Bank of England base rate still at its 0.5 per cent low, they are highly likely to provide you with a better rate than your easy access products.
Currently the highest interest-paying instant access accounts are offering around three per cent interest.
Meanwhile the top savings bonds can earn you interest at more than five per cent.
But there is a pay-off for receiving these more attractive rates – you will need to lock your money away for a specified period of time.
This could be anything from six months to five years. And, it probably won't come as a surprise to learn the accounts which tie up your cash for the longest are the ones which pay the highest rates.
What's more, there's also little flexibility in many of these accounts.
Still interested? Well, here's our step-by-step guide to investing in Savings Bonds.
Decide what you want your money to do
If you need a savings account which you can access at any time – maybe for emergencies, or perhaps to pay for family treats – savings bonds are probably not for you.
They are, in many ways, mini investments because unless you are willing to lock up your savings you won't receive the best rate.
Although you won't necessarily be refused your cash if you do want to withdraw it, you may be charged a penalty or could lose all your interest.
What's more, many savings bonds do not allow you to deposit cash. They simply provide a place for a lump sum to mature.
For this reason, savings bonds are for savers with a wad of cash which they know they won't need to access for a while.
Some people run two savings accounts – an instant access they can dip into – and a savings bond or fixed-rate account for longer-term goals.
What sort of bonds are available?
The next step is to decide what bond to choose. There are many on the market and if you are new to this kind of saving the choice might be a little overwhelming.
Start by looking at the different types of savings bond. A fixed-rate bond will pay you the same rate of interest for the length of the bond.
If you sign up for a five-year bond paying 4.95 per cent, that's what you'll receive for five years.
The advantage is that you will be guaranteed this rate no matter what happens – whether interest rates are low (as they are now), whatever is happening to inflation and no matter what the markets are doing, your bond will not be affected.
On the downside, if interest rates soar to more than your bond's interest rate, you will lose out.
Inflation-linked bonds will also tie your money in for a set period of time. The interest rate will track one of the measures of inflation.
If inflation is low, your rate will be low. But during times of high inflation – such as now – you'll be enjoying a hugely competitive deal.
Unfortunately, you cannot always guarantee what inflation will do so you will be taking a gamble by opening one of these accounts.
This is especially true if you lock in your money for a longer period.
Also on the 'bond' market are more complex bonds which track indices, such as those on the stockmarket.
They work on the same principle as savings bonds in that they allow customers to put a lump sum of cash into an account for a set period of time.
However, they provide interest based on the level of, for example, the FTSE100 index. If its value goes up so does your rate, but if it goes down, your interest will fall.
These products are probably a little more sophisticated and much more risky than savings bonds and you will probably need advice from a financial adviser before signing up.
Read more: A guide to inflation linked savings accounts
What else should I look for?
As you will have gathered by now, the longer you lock in your cash into a savings bond, the better your rate. You need to decide how long it will be before you need your cash and interest.
For example – if you are saving for a holiday to Australia in 2016, a five year account would be perfect.
But if you are putting away cash for your wedding in 2012, you might want a shorter-term deal.
Make sure you check out if there's a minimum investment on the account. Many bonds require a lump sum, and this can often be as high as £1,000. In some cases you might even be looking at a five figure sum.
Also find out whether there are any rules on depositing cash. Some bonds will not allow you to make additional deposits after you've invested the initial lump sum.
Meanwhile, there are bonds which require just £1 to open and which allow regular deposits.
Make sure you check out the penalties – if any –for withdrawing cash too. Some bonds will not allow withdrawals during the fixed-rate period, taking money from others will mean you'll forfeit your interest.
Is now a good time to get a fixed rate?
With interest rates still low, opening a fixed-rate savings account today will obviously be beneficial now.
But if the interest rate soars, you could end up on an uncompetitive deal.
Kevin Bray of independent financial research firm, Defaqto, said it is difficult for people to judge whether they should opt for a longer-term savings option.
He added: "If opting for a fixed savings account at this point, a key aspect to consider is whether and how much flexibility should be built in to ensure someone does not lose out if the base-rate increases."
Defaqto recommends hedging your bets by spreading savings between instant access accounts and bonds.
This will provide them with the opportunity to take advantage of better savings rates which become available when the Bank of England base rate increases.
It also suggests people with a big savings pot split their money between one, two and three year bonds to ensure all their cash is not tied up for the long-term.
He recommends consumers consider bonds which allow penalty-free withdrawals as this will give them greater flexibility with their money.
On the other hand, interest rates could remain low for some time. In this case a fixed-rate bond which allows additional deposits could help you make the most of this scenario. Defaqto suggests exploring this market too.
Before signing up
Once you have found the product for you, it's essential you check the terms and conditions. Although you may have chosen your bond based on its withdrawals and deposits policy – it's still worth checking in detail how it works.
If it's possible to wrap an ISA around your bond – which is common among the inflation-linked variety – make sure you take advantage of your tax-free allowance.
Use the Myfinances.co.uk comparison tools to find the best deal on a savings bond
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