Your ultimate guide to UK savings

The safest place to hold your money in the short-term is in cash.

Sounds obvious, but cash is money. Shares, property, bonds, gold and pension funds are all assets whose value constantly fluctuates according to the whims of their markets. You can only be certain what such assets are worth when you come to sell them.

In sharp contrast, while the real value of a £20 note will go down due to inflation over the long-term, short-term it’s the safest store of value there is. You know it’s worth exactly… £20.

The price for this safety is you can expect lower returns from cash compared to investing in shares, over periods of five years or more.

Note that I’m talking here about keeping the interest you receive in the savings account, to benefit from compound interest over time.

If instead you spend the interest you receive, the real value of your savings will go down with inflation. Right now that would mean your cash would lose 3-4% of its spending power every year.

Despite the low returns, everyone needs some cash stashed away for a rainy day – or more specifically for when the roof leaks and you need to get it repaired.

You’ll also want cash savings for near-term known expenditure, such as school fees or a house deposit. You don’t want to lose your dream home because the stock market happens to be having a bad month when you come to buy, for example.

You might also keep some proportion of your long-term investment money in cash, depending on your views on the stock market, and increase the proportion in cash savings if you’re feeling very gloomy.

Just remember, over time you risk losing out to inflation, so you really want your long-term money in assets like shares or property.

Cash savings are the simplest of investments, but there’s still plenty to cover. Let’s get going.

Interest rates – very interesting

The interest rate of a savings account reflects the amount of cash you get back in return for loaning your money to the bank. For instance, if you put £100 into a bank account paying an annual rate of 5% interest, then you’d expect to get £105 back after 12 months.

Without getting too technical, UK banks’ interest rates are influenced by two main factors – the central Bank of England’s base rate, and how keen a particular bank is on getting your money. (Banks that are competing more aggressively will offer higher interest rates.)

You also need to know the difference between fixed and variable interest rates.

• Fixed rate accounts ‘lock’ the interest rate at some set value over a specified time period – typically 12 months for savings.

• Variable rate accounts (the kind of savings accounts we’re all more used to) fluctuate over time with base rates and the marketplace.

For complete security then, you can put your money in a product with a fixed savings rate. This way you know exactly what you’re getting, and you can budget to the pound how much money you’ll have at the end of the term.

However fixed rate savings accounts are rarely the highest paying in the market, particularly at times of rising base rates. For that reason variable savings rate accounts are much more commonplace, and generally a better choice for most savers, especially since it’s easy to get savings accounts that allow you instant access to your money.

Alas if the Bank of England cuts interest rates, you can bet the variable rate you get for your savings will soon fall.

Variable rates can rise too, of course, when the Bank of England lifts the base rate. For some reason though the banks never seem in quite such a hurry to pass on base rate increases to savers!

Banks love lazy savers

If a bank can, it will get away without paying you much interest on your money at all.

A bank account paying 0% interest still gives you the benefit of your money being somewhere secure and a debit card, so you might think that’s okay.

Your bank certainly does – it’s investing your money elsewhere for its own ends and enjoying all the profits itself.

Most UK current account holders are in exactly this position, with the banks benefiting from the huge sums of money we’re all too lazy to move out of our 0.1% paying current accounts and into higher paying savings accounts.

At least the savings market is more competitive. When people have a set sum earmarked as a nest egg, they’re usually well aware of the need for a good interest rate and are prepared to shop around for one, or to ask their own bank to open up a second interest-paying savings account for them. Be sure to keep an eye on the personal finance pages, which do a good job of highlighting the best savings rates on products.

Savings accounts therefore typically have a much higher rate of interest than current accounts (the better ones paying more than the Bank of England’s base rate) because banks know they have to compete to get this tranche of your money.

By the way, there’s no good reason why your savings account needs to be with the same bank as your current account. The days of the friendly neighborhood bank manager are long gone for most of us – in such impersonal times, you’re better off just chasing the interest.

Current accounts: cheap and cheerless

Most of us pay our wages into the same current account we’ve had since we started work or University and never get around to changing it. (It’s been calculated you’re more likely to get divorced than you are to change your current account!)

As mentioned, current accounts are the worst places to hold your money long-term, since they nearly all pay derisory interest. The typical major name High Street bank will pay you something like 0.1% interest on your current account balance, although one or two have started to compete more aggressively.

Exact deals change all the time, so shop around.

Even if your current account does pay you some interest, don’t leave money lying around in it forever. There will definitely be dedicated savings accounts out there that will pay better, so open one for your surplus cash ASAP.

Indeed, the best way to think of your current account is as a clearing house for your money before it goes elsewhere.

Choose and evaluate such an account for the service you receive, the availability of local branches, or the charges should you go overdrawn (not that you’ll let that happen to you, I hope), and keep your savings elsewhere.

Online savings accounts

Internet-managed accounts invariably offer the best interest rates of the standard savings accounts. Even better, online savings accounts usually offer penalty-free access to your money, unlike old-fashioned notice acounts (I’ll get to them later).

You should expect an interest rate of at least 0.5% above the Bank of England’s base rate from a newly opened online savings account. As I write, the UK base rate is 5.75%, and the best online savings accounts are paying 6.4-6.5%.

These seemingly small differences between interest rates really add up. For example: £20,000 saved for five years at 6.5% will return you £27,402. The same sum held for five years at 4.5% will return you merely £24,924 – a difference of £2,478!

Banks can afford to pay online savers more because they keep their costs low. They don’t have to build you a local branch for you to visit to deposit your money, they will encourage you to manage your account via the Web and email, rather than via paper and the post, and they can outsource the behind-the-scenes management of your account overseas.

None of this cost-cutting should be visible to you as an online saver. Demand a good, prompt and reliable service, and if you don’t get it move your money elsewhere.

Online savings accounts frequently change their rates as they jostle for market share: You’ll find the current best payers via Internet sites such as Moneyfacts, or listed in Best Buy tables in the personal finance sections of the weekend newspapers.

When choosing a savings account, look for a big name you’ve heard of, or else be prepared to do some research to establish the credentials of the bank.

For instance, one of the top paying accounts at the time of writing is from a newcomer called Icesave, which you’d rightly give a frosty reception to – until you learned it was backed by Landsbanki, one of Iceland’s oldest and most established financial institutions.

A final complication, which applies to savings accounts of all kinds, is that banks usually cut their fancy ‘teaser’ rates after a year or so, and hope customers don’t notice their money is no longer in a top-ranked performer. Worse, they sometimes pay older customers a lower rate, while bringing in new customers on a higher one.

Rotten though it smells, this is inevitable in the current market, and you won’t want to move your money every time a new entrant leapfrogs your chosen bank in the tables – you’d be opening savings accounts every month, which is a time-consuming process given all the money laundering safeguards in place these days.

Still, you should certainly consider moving your money if the interest rate gap between your account and the best payers increases by more than about 0.5%.

Alternatively, look out for consistent high payers over the years, or for any guarantee that the savings rate will closely track the bank rate. Such steadily competitive accounts can save you a lot of hassle.

Notice and postal accounts

Before the Internet, the best interest rates for savers were reserved for those who were prepared to lock away their money and accept up to a three-month wait if they wanted to withdraw their cash without losing interest.

These Notice accounts still exist and are used by technophobic or older savers, but in my view they’re best ignored today if you’ve Internet access – the rates are no better than the best online savings accounts, and the latter give you instant access to your cash.

Some argue the notice period is a benefit, since it stops weaker savers dipping into their savings when they shouldn’t.

I’d prefer to work on my willpower and commitment to my long-term financial goals than allow a bank to tell me when I can get at my own money, but if you really feel a notice period would help then by all means investigate them.

Once again, look for higher interest rates than the Bank of England’s base rate. And be wary of catches in the small print – make sure you know what penalties do apply if you withdraw your money early.

Special ‘bonds’ that are really savings products

Every now and then a major bank or building society will advertise a savings ‘bond’ with a term of between 1-3 years. They’re not bonds in the stock market sense of the word. It’s just a term the banks use to conjure up feelings of security.

Unlike conventional Notice accounts, these ‘bonds’ can pay a superior rate of interest. Nationwide was recently offering a one-year savings bond with an interest rate of 7%, compared to the best online rates then of about 6.25%. If you were prepared to lock away your money for a year, it was well worth considering.

Notice I say ‘was’. Nationwide’s 7% product is now closed to new savers; these so-called bonds tend to only be available for short periods before they’re oversubscribed and withdrawn.

Another drawback is with some you can’t get your money out on demand – even if you’re prepared to lose the interest! If this applied to a savings bond I was investigating, then I’d not lock my money away for more than a year. A lot can change in 12 months, let alone 36 of them.

Once again, be very careful to make sure you know what you’re buying whenever you read the word ‘bond’ – the term is slapped on all kinds of products. It’s probably safest to only consider the biggest names, and make sure the bond is a cash savings one offering a 100% capital guarantee and a guaranteed rate of interest – exactly what you’d expect from a savings account, in other words.

Anything else (particularly a ‘Guaranteed Equity Bond’) will be linked to the stock market, which isn’t what you’re after here at all.

Regular saving accounts

That’s regular as in ‘frequent’, not as in Americanisms like ‘regular fries’, by the way.

Unusually for a financial product, this kind of account’s name is quite accurate – it pays you a high rate of interest, even higher than a normal online savings account, provided you’re prepared to regularly pay in a certain sum of money every month.

You can get between 8-11% interest in the best regular savings account at the time of writing, compared to 6% from an averagely competitive standard online savings account.

Sounds good: What’s the catch? Unfortunately, there’s two.

Firstly, there’s always a cap on how much money you can transfer over every month, usually between £200 and £500. Some have maximum balances, too, or else pay a reduced rate of interest on sums over say £2,000.

Secondly, these regular accounts only run for a fixed period, normally a year, after which your money is moved into one of the bank’s standard savings accounts, which you can bet has a lower rate of interest (almost certainly lower than a rival online account).

Together these catches limit the effectiveness of regular savings accounts if you already have cash savings to deposit, since only your first monthly transfer will benefit from the full 12 months at, say, 8%. A transfer made after six months will get only six months interest at the high rate, and so on.

One sneaky way around this is to pipe money from your standard online savings account to the regular saver account, and to close down the regular saver after the 12 months is up.

This way your savings are always growing at the maximum rate – either in your core online saver account or in the topped-up regular savings account – and by moving out your money and shutting down the account at the end of the term you’re beating the bank at its own game, since it expects you to accept the second savings account out of sheer laziness.

Some enjoy this kind of sport, but to be honest I prefer a simple life when it comes to cash savings, and would suggest you concentrate on finding a decent online account and applying your effort and brainpower to your more high-powered investments.

All of this is only an issue when it comes to savers with existing lump sums to house, of course. If you’re only just starting to save cash (or if you’ve committed to saving fresh funds out of your income) then the size limit issues don’t really matter and the accounts are worth looking into.

Just be sure you move your money somewhere more competitive when the high rate period ends.

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Tax, horrible tax

I’ve a secret to reveal – in my zeal to get you excited about saving, I haven’t mentioned the income you get via interest will be taxed.

Well, it is. Sorry. (No, I don’t like it either).

Savings income is taxed at your highest rate of income tax. Basic rate payers will lose 20% of their interest, but if you’re a higher rate tax payer, you’ll be looking at 40% of your interest going back to the government. With RPI inflation currently running at between 3-4%, your money will therefore be losing its value over time. You’re actually getting poorer! (I told you inflation was nasty).

This is the price of the security and ready availability of cash savings, compared to stock market or property investing, which if sensibly conducted over the long-term is likely to beat inflation.

You can see the Government’s own website for the full gory details on the tax rates for UK savers.

However, there are also various ways in which you can (legally!) avoid paying tax on your savings. Let’s consider a few.

Cash ISAs

An ISA – it stands for Independent Savings Account – is a special type of account, introduced by the government to encourage you to save.

The perk is you don’t pay tax on the interest. Every year, each UK citizen has an allowance for how much they can put into an ISA, currently £3,000. These savings can be carried into future years, but if you withdraw any money from an ISA then that portion of your tax-free allowance is lost (i.e. you can’t move money in and out).

There are two distinct types of ISAs, cash ones, and share ones, with providers offering all kinds of variations of the latter.

In total you can save £7,000 across the two kinds of ISAs per year; a saver putting the maximum £3,000 into a cash ISA would also be able to put £4,000 into a share one.

The best cash ISAs pay an interest rate equal to the best online savings accounts, but with the huge benefit that none of the interest will be taxed. This makes a big difference – a 6% untaxed rate in an ISA will generate roughly as much money as a taxed account paying 10%, if you’re a higher rate tax payer.

Clearly everyone should use up their annual ISA allowance every year if possible, especially given that you can’t get it back once the tax year has closed.

The main downside of Cash ISAs is that the tax savings are arguably even more useful for long-term share investors, who may well prefer to use their full £7,000 ISA allocation with a share ISA account, leaving no allowance left for a cash one. You’ll have to make your own decision on this.

Cash ISAs are available from all banks and building societies. Make sure it’s a cash ISA you look for, so you’re not sneakily bumped into some expensive share-based one. (Cynical? Moi?)

Ideally, put your longer-term cash savings into cash ISAs, since you lose the tax-free allowance on any money you withdraw. Take any cash required out of your standard online savings account first.

I know this cash ISA stuff sounds complicated. It isn’t as bad as it appears once you apply some time to reading up about it (see the Government’s own ISA help page) but personally I still think they’re more convoluted than they need be.

Unfortunately the same is true of the next best tax-free savings method…

National Savings Certificates

The National Savings investments we’re interested in here are certificates issued by the government. There are various types, which I’ll go into a minute. The ones we’re after pay you tax-free interest on your savings.

National Savings Certificates are best thought of as a scheme set-up by the government to encourage saving – but not too much of it.

As with ISAs (which, incidentally, are also offered by National Savings), the amount you can put into National Savings Certificates is capped in any particular year. Like this, the government aims to reward more modest regular savers, as opposed to giving millionaires an official tax-free haven for their loot.

Two types of National Savings Certificates are available – fixed, and index-linked.

The fixed ones pay you a (surprise, surprise) fixed rate of interest.

The index-linked ones pay you a smaller rate of interest, plus an allowance for inflation, as determined by whatever the current Retail Price Inflation (RPI) index is showing.

In both cases the interest rate seems quite low, until you remember that the income is tax-free. As we saw above with ISAs, for higher rate income tax payers especially this makes a huge difference. For example, the current National Savings fixed rate of 3.6% is equivalent to 6% for a higher rate tax payer.

That said, basic rate tax payers may well find they’re better off with a top-rated online savings account when it comes to interest. As interest rates constantly change, you’ll have to do the sums for yourself when you read this article.
One final advantage of National Savings Certificates is that your money is 100% backed by the government, so you needn’t fear a bank run like the recent Northern Rock fiasco. This applies however much money you have in National Savings, as opposed to the current £35,000 per account limit on conventional bank deposits.

Downsides? There are a few. In particular, to invest in the Certificates you need to lock away your money for years to get the interest, since the certificates come with a fixed duration.

Terms currently range from two years to five years. They are therefore best for wealthier savers with large sums of cash to stash away, or more modest savers who know they will need a certain amount of cash in a certain number of years (e.g. for school fees, or to buy a house).

They’re also a fair second choice for anyone who hasn’t yet been convinced that their long-term savings should be in the stock market – although sooner or later your savings will be outpaced by shares.

You certainly don’t want to put your rainy day fund in a Certificate with a two-year fixed term, that’s the main point. Emergency funds need to be instantly available, without penalty.

Another downside is that there’s a limit to how much you can put away into National Savings Certificates in any one year, however much money you have to hand. The Government only issues a few certificates a year – with each issue having a particular term and interest rate – and you can invest a maximum of £15,000 in each one.

It’d be churlish though to look this gift horse in the mouth, and you can certainly ferret away significant sums from the tax man’s reach in these investments over time.

Of course, the fixed interest rate products do present the usual dilemma of locking down an interest rate. You’re in essence gambling the Bank of England won’t raise interest rates significantly while you’re money is tied up at the fixed rate (or better still that they’ll cut base rates, rewarding your prudence).

It would be pretty dispiriting to lock away £15,000 for five years, only to see interest rates outside of National Savings double in that time.

That said, you can get your money out before the end of term, if the situation was to get that drastic, albeit at a cost of reduced interest.

Personally, I think the index-linked Certificates are the more interesting National Savings product. It’s hard for a everyday savers like you and me to get easy access to inflation-proof products elsewhere in this country, and as I’ve said above inflation proofing is about the best you can hope for when it comes to your cash savings.

If you’re after 100% security for your money, inflation-proofing plus a government backed guarantee is hard to beat.

You can read more about tax-free Certificates on the National Savings website, which is also where you can invest in them.

Premium Bonds

I’ll just briefly mention Premium Bonds, which are also run by the Government’s National Savings wing, since most people consider them a savings product.

You can invest up to £30,000 in Premium Bonds in total. According to how much you invest, every month you get a number of ‘tickets’ in the Premium Bonds prize draw. Instead of interest, you take your chances on winning a prize in this draw. Prizes range in size from £50 up to a cool million.

Over the year, the Government puts in cash prizes equivalent to a percentage of the total amount invested in Premium Bonds – this is effectively the interest rate on the country’s entire pool of Premium Bond savings. Prizes are tax-free, and you can get your money back out within 10 days without penalty, making them more suitable from a ‘rainy day’ fund point of view than other National Savings products.

You might then think of Premium Bonds as a rather random bank account. If you’re lucky you’ll win slightly more than your fair share of prizes. If you’re unlucky you might win none. And if you’re very, very lucky you’ll win one of the two million pound payouts given away every month.

Your initial capital is always safe in any case, as with a normal bank account.

I don’t personally like Premium Bonds. While I’d like to win a million pounds as much as the next person, the odds typically suggest I’ll in reality get less money back than in a normal bank account.

Deciding whether Premium Bonds are a good investment at any point in time takes some number crunching, but whenever I’ve looked, my odds on winning a million are better if I were to put my money into the best online savings account, and bought lottery tickets with the difference (which I don’t do either, as it happens).

Sometimes the effective interest rate (the prize payout) looks more tempting (as I write it’s a high-ish 4%, tax-free). But the fact remains that the two monthly million pound prizes and the other bigger prizes pull down the interest rate that most bond holders are likely to enjoy.

At 4%, I’d say Premium Bonds might interest higher rate payers who’ve filled up their ISAs and taken out all their National Savings Certificates.

But basic rate or non-tax payers are better off putting their money elsewhere. Unfortunately, Premium Bonds are the only savings some of these people have, particularly as they’re popular with the elderly.

You can make up your own mind and buy Premium Bonds from the National Savings website.

Finally: How safe is your cash?

Time was when we all trusted our money was safe in the bank, at least if it was one of the big names, but the Northern Rock run of Summer 2007 has made people think twice about their savings.

This is a very fluid area, since the Government is currently looking at how to extend the protection it offers to savers to avoid another bank run.

Its first move has been to slightly increase the protection limit to £35,000.

If a British bank goes bust then, you’re guaranteed to get £35,000 back. After that, who knows? The chances are high that in the extremely unlikely event of such a bank going bust, the Government would guarantee all your savings. But officially, any money over the £35,000 limit is not currently protected.

The most prudent thing to do therefore is to spread any very large savings amounts between several banks. If you have £70,000, for instance, you might put it into two online savings accounts run by different banks, so both tranches of £35,000 are safe.

For ultimate security for your cash, you can put it in the Government-backed National Savings products mentioned above. Short of a revolution or nuclear war, you’ll definitely get your money back. The Government can print money, after all, and so it will always honour its commitments. For some, the fractionally lower interest rates might be a price worth paying for absolute peace of mind.