Savings Explained
Whether you are saving for a rainy day, for a holiday or for a big-ticket item such as a car, it makes sense to seek out the best possible interest rate. Making your money work as hard as possible for you will enable you to reach your goal sooner and will also prevent inflation devaluing your savings.
What types of savings account are there
The savings account you opt for will depend on a number of factors including the amount you want to save, how frequently you will be putting money away and what access you will need to it.
Easy Access Accounts
The most popular type of savings vehicle is an easy access account (also often called a no notice account and an instant access account).
As their name suggests these products give you immediate access to your cash, making them ideal for your rainy day savings pot which you may need to dip in and out of.
Millions of savers have an easy access account with the same bank or building society they have their current account with. These products are easily sold as they offer a higher rate of interest than the rate you are probably getting on your current account and are therefore ideal if you have money to spare each month. While all of this is true, the rates on easy access accounts vary hugely so it is well worth shopping around to ensure you are getting a good deal.
Rates tend to be variable so they tend to go up at times of rising interest rates and down when Bank rate, the country's official interest rate, is cut. However, your savings rate will not necessarily move in line with Bank rate so it is important to keep an eye it and be prepared to move your money elsewhere if the rate becomes uncompetitive.
Notice Accounts
If you do not need immediate access to your savings a notice account is worth considering. These products permit withdrawals but you must give a certain number of days' notice – usually 30 days, 60 days, 90 days or 120 days - before you can access your money. If you need your money more quickly than that you will face a penalty.
As with easy access accounts, interest rates tend to be variable. Traditionally, notice accounts have paid higher rates of interest than easy access accounts and the longer the notice period, the higher the rate. However, that is not necessarily the case any longer. The best easy access accounts currently offer rates on a par with the best notice accounts, so you may find there is no need to sacrifice flexibility in order to maximise returns. It is therefore important to compare rates on both types of product when looking for a savings account.
Fixed rate bonds
Available from banks and building societies, fixed rate bonds pay a set amount of interest for a certain period of time. At the end of the term you get your capital back, plus interest.
The length of the term can be anything from six months to five years. Generally speaking, the longer the term, the higher the interest rate.
However, you cannot usually access your money during the fixed rate term, so this type of account is only worth considering if you have money you can afford to lock away.
Fixed rate bonds are also only suitable for those with a lump sum to invest as most do not permit you to add to your initial deposit. The minimum deposits can be quite high - £10,000 is not uncommon. However, many accounts have lower entry requirements than that.
If you are considering investing money in a fixed rate account, you need to think about the general interest rate environment. Fixing your savings rate can be a great idea, particularly if interest rates are falling. However, there is a risk: you could be stuck on an uncompetitive rate if interest rates rise significantly during the fixed rate term.
Consequently, one and two-year deals tend to be most popular because if interest rates do rise sharply, you will not be tied in for too long.
Regular saver accounts
Regular saver accounts are relatively recent addition to the savings market that will appeal to those looking to save on a monthly basis – such an account could be the ideal savings vehicle if you are putting money away for a specific purpose, maybe a holiday, car, wedding or Christmas.
The interest rates on accounts of this kind are often significantly higher than those on easy access, notice accounts and fixed rate bonds. They are usually fixed, rather than variable, and run for a set term – typically 12 months.
Most accounts require you to deposit money every month and many do not allow you to change the amount you pay in during the term. You therefore need to decide how much you can afford to save at the time of opening.
There is usually an upper limit on the amount you can pay in each month – often £250 or £300. The minimum deposits tend to be set quite low, between £10 and £25 a month, so even if you do not have much money to spare, you can still take advantage of a great rate and get into the habit of saving regularly.
Individual savings accounts (ISA)
Cash ISAs work like any other savings account, the only difference being that the interest you earn is not taxed. Savings interest is normally subject to income tax (see How is interest paid? for further detail).
Savers under the age of 50 can invest up to £3,600 a year into a cash ISA. The annual allowance for the over-50s is £5,100 - all savers will benefit from this higher limit from April 6th 2010. There are different types of account – easy access, fixed rate and notice accounts – and interest rates vary. It is therefore worth comparing rates to ensure you get the best deal.
While you cannot pay more than the annual allowance into a cash ISA in any one tax year – £3,600 or £5,100 depending on your age – you can move money invested in previous tax years without losing the tax break.
However, if you withdraw money from a cash ISA you cannot reinvest it. If you want to switch cash ISA provider, you therefore need to make sure you arrange a transfer. If you close your existing account and withdraw the money you will lose the tax-free status and will not be able to pay the money into your new ISA account. Read our ISA guide for more information.
Over 50s accounts
You may think it 'ageist' but some savings accounts are available to the over-50s only. Providers that offer such deals tend to pay a higher rate of interest on these accounts than on their standard savings deals. However, this does not mean Over 50s accounts pay the best rates. Even if you are eligible for such deals, it is still worth checking to see what savings rates are available on other product types.
Affinity accounts
Sports enthusiasts and charitable souls may be attracted to an affinity account that is linked to their favourite team or cause.
You do not usually get the best rate of interest with affinity accounts because some of the income made from your cash goes towards the affiliated cause. You should therefore see how the rates compare with standard savings accounts and decide whether you would prefer to support your favourite team or charity in this way, or maximise your returns.
Offshore accounts
Many high street banks and building societies offer offshore accounts, as do private banks. They are usually based in the Channel Islands and the Isle of Man because the tax jurisdictions differ from the mainland.
Unlike standard savings accounts where interest is paid net of basic rate tax, interest on offshore accounts is paid gross. You must still pay tax: any income from savings must be declared on your self assessment form.
However, the deferral of tax in this way can be useful and boost your overall return the money that would otherwise be automatically deducted stays in your account for longer.
Most offshore accounts are available to anyone over the age of 18 (although some are only open to those living outside the UK). However, the entry requirements are quite high. The minimum deposit tends to be £5,000 or £10,000, so it is only wealthier savers that can take advantage.
The rates on offshore accounts used to be higher than those on onshore savings vehicles, but that isn't necessarily the case any longer. They are therefore most popular with people who live or work outside the UK – many allow you to invest euros or dollars, as well as sterling, which makes them very useful if you derive some of your income in a foreign currency.
It is also worth noting that offshore savings accounts are not covered by the Financial Services Compensation Scheme so you should check what protection you would have in the event of the bank going bust.
Guaranteed equity bonds
Guaranteed equity bonds (Gebs) provide a half-way house for investors who want exposure to the stock market, without taking on the full risk.
Gebs are linked to a stock market index, usually the FTSE 100 or FTSE All Share, and they run for a fixed term. The return you get will depend on what has happened to the stock market over that time. However, the main attraction of Gebs, is that if the market falls you will not lose all your money.
Gebs guarantee to pay a minimum return. This varies depending on the product, but some will promise to repay all the capital you invested at the outset, while others repay a proportion of it.
This protection comes at a price, however. If the index your investment is linked to rises over the term, you will not benefit from the full uplift and dividends tend not to be included.
Returns are usually based on a proportion of the growth and they tend to be calculated using averages rather than the percentage increase over the fixed term.
For example, the FTSE 100 may rise 20% over a three-year period. However, this does not mean you will get back 20% more than you initially invested. Instead, the return may be calculated using the index level at the start date and the average daily closing level over the final year of the term. It sounds complicated, and it is complicated. It is often very difficult for individuals to work out exactly how much they will get back when their Geb matures.
When comparing Gebs, you therefore need to read the small print and ensure you understand how your returns will be calculated. You can then decide whether the price you are paying for capital protection is worth it.
National Savings & Investments
Products from National Savings & Investments (NS&I) are a popular choice with savers because the firm is backed by the Government and it is therefore seen as the safest home for your money.
NS&I offers a range of savings vehicles including tax-free accounts, fixed rate deals and inflation-proof accounts. However, the interest rates are not always that competitive so it is important to see how NS&I's deals compare with other savings accounts the market.
While not protected by government-backing, money deposited with banks and building societies is covered by the Financial Services Compensation Scheme. In the event of an institution going bust, the first £50,000 is 100% guaranteed.
Is there anything I need to watch out for when choosing a savings account?
Minimum deposits
Some savings accounts require a minimum deposit. So, you can only take them out if you have enough money to meet the deposit conditions.
Generally speaking, fixed rate bonds, offshore accounts and guaranteed equity bonds have high minimums, in some instances £10,000 or more, but a number notice and easy access accounts are also ask for minimum deposits.
Traditionally, the bigger the balance, the higher the interest rate, but this is no longer the case. Many of the highest-paying easy access accounts are available on balances of £1 or more.
Short term bonuses
One other thing to be aware of is that many banks and building societies offer headline interest rates that include short-term bonuses that apply for the first six or 12 months.
If you opt for an account of this kind, you will therefore have to switch accounts once the bonus period ends to ensure you are getting the best rate over the longer term.
Withdrawal restrictions
As mentioned above, some savings accounts also carry withdrawal restrictions. You may only be able to make a certain number of withdrawals in a 12-month period, or you may receive no interest in the months you withdraw cash.
This is worth noting as it can have a significant impact on the amount of interest you receive over the course of a year.
If, for example, you had £5,000 in a top savings account paying around 6%, just one withdrawal in the twelfth month would cost you about £20 in interest and would reduce the actual rate you receive by about 0.5%.
Linked Accounts
There are also some savings accounts that you can only take out if you have another account with the same bank or building society.
What is a dormant account?
Dormant accounts are savings accounts that have money in them but have not been accessed for a specific period. They are often accounts that are no longer available to new customers and the rates of interest paid on them tends to be low.
So, if you've got money in an account you'd forgotten about, contact the British Bankers' Association for information on how to trace it and move your cash to a better home.
How is interest paid?
Interest on savings accounts is generally paid either monthly, or annually. Those that pay annual interest often offer a better deal if you are saving for the long term – in other words if you will not need to make any withdrawals over the course of a year.
If you expect to dip into your savings, however, you may well be better off with a monthly interest payment.
One other point to remember about standard savings accounts is that any interest you receive will be taxed as income.
The first £5,435 of income is tax free. You pay 20% tax on the next £36,000, and 40% on any income above that amount.*
But beware. Most savings income is automatically taxed at 20%, meaning you must register to receive interest before tax (or claim back the tax you have already paid) if you are a non-taxpayer.
You need to fill out an R85 form, to register for savings income to be paid gross. If tax has already been deducted from your savings' interest, you can claim it back by completing an R40 form.
If you are a higher-rate taxpayer, you must pay the additional 20% tax through your annual tax return.
*Correct for 2008-2009 tax year.
How is interest displayed?
Gross
This is the rate of interest, displayed as a percentage, before tax.
AER
This stands for Annual Equivalent Rate. It is displayed as a percentage and indicates what the rate of interest would be if interest was compounded. The AER will be higher than the gross rate, if interest is paid monthly.
Regulation
Financial Services Compensation Scheme
UK savings providers are regulated by the Financial Services Authority (FSA) and any money you deposit with them (with the exception of offshore accounts) is protected by the Financial Services Compensation Scheme (FSCS).
The FSCS offers protection in the event of a financial institution going bust. Under the terms of the FSCS, the first £50,000 of an individual's savings is fully protected. If an account is in joint names, £100,000 is 100% guaranteed.
However, this applies per institution and not per account, so if you had two savings accounts with the same provider, you would still only be protected up to a limit of £50,000. If you have a large amount in savings it is therefore worth spreading your money between different institutions. Beware though, some institutions have the same parent company. For example Halifax, Bank of Scotland, Birmingham Midshires, The AA, Saga and Intelligent Finance are all part of the HBOS group and if you had a Halifax savings account and a AA savings account, only £50,000 would be protected by the FSCS.
Click here for more information about the protection offered by the FSCS.
Banking Code
Most banks and building societies are signed up to the Banking Code. This is a code of conduct relating to the way financial institutions treat their customers.
Under the terms of the Banking Code, banks and building societies must inform customers when they change the interest rates on their accounts. However, they only have to notify customers individually if the margin between the savings rate and the Bank rate widens by more than 0.5 percentage points within any 12-month period.
Customers must also be notified personally if the margin widens by 0.26 points or more following a single Bank rate increase or decrease. Any less, and the changes need only be displayed in branches, newspapers and on the provider's website.
Institutions are also under no obligation for them to inform customers about new higher-paying accounts. You should therefore keep a close eye on your own rate, as well as regularly checking what else is available to avoid missing out.
If you want to open a new account, or make a withdrawal from a branch, you will have to provide proof of your identity. This is to prevent criminals using savings accounts for money laundering purposes and to stop other types of fraud.
