ISAs versus fixed rate bonds - which is best?

Published:
02 December 2010
Topic:
News,Money,ISA,Savings

Fixed rate bonds continue to prove hugely popular with savers due to the high rates of interest they offer - but you can earn even better returns by opting for a fixed rate ISA.

Despite the fact that the rates of interest on fixed rate ISAs tend to be marginally lower than those offered by fixed rate bonds, the fact that interest is tax-free means that you will usually end up with more cash in your pocket by the end of the fixed rate term.

For example, research by moneysupermarket.com found that the average rate for a one-year fixed rate bond is currently 3.04% compared to 2.97% for a one year fixed rate case ISA.

But, once you factor in the tax-free benefits, a cash ISA paying this rate could earn you £151.47 in interest over the year, assuming you invested the maximum £5,100 allowance this year. In comparison, you would earn £124.03 interest on the same amount if you had invested it in the average one year fixed rate bond, once basic rate tax is deducted. That's £27 less than if you'd picked the ISA at the lower rate.  Savers would need a standard fixed rate bond paying more than 3.75% to beat the ISA.

Kevin Mountford, head of banking at moneysupermarket.com, said; "ISAs are a great way for savers to make the most of their hard-earned cash as they do not have to pay income tax on the interest earned. Our analysis shows that even though one-year fixed rate bonds pay a higher rate of interest, the tax benefits of a one-year fixed rate cash ISA outweigh the higher interest rate of a one-year fixed rate bond."

Best fixed rate ISAs

You can invest up to £5,100 in a cash ISA this tax year (the tax year ends on 5 April) and it's well worth taking advantage of this valuable tax-break.

There are plenty of competitive fixed rate cash ISAs to choose from. If you want a one-year account, Northern Rock is paying 3.05% on its Fixed Rate ISA Issue 150, which matures on January 15, 2012. This is a postal account and the minimum amount you can invest is £500. Withdrawals are allowed, but you will lose 60 days' interest on the amount withdrawn - so try and avoid touching your money during the fixed term if possible. You cannot transfer savings held in other ISAs into his account.

Marks & Spencer Money has a one-year fixed rate ISA paying 3.00% if you invest £500 or more.

Leeds Building Society also has a one-year fixed rate ISA paying 3.00% which actually has the edge over the M&S deal as it is available on balances of just £1. What's more penalty-free withdrawals are allowed during the term which is unusual for fixed rate deals, although the maximum you can withdraw is 25% of the investment. So if you invested £1,000 the most you could take out without penalty would be £250.

If you have money you can afford to lock away, there are even higher rates available. Northern Rock's five-year Fixed Rate ISA Issue 152 is paying 4.10%, while its three-year fixed rate ISA Issue 151 has a rate of 3.50%.

Easy access ISAs

Locking into a fixed rate ISA may not suit everyone, especially if you think you might need to get your hands on your savings quickly.  Easy access ISAs tend to pay lower rates than their fixed rate counterparts, but the tax-free advantages still often make them more attractive than non-ISA fixed rate bonds.

Kevin said: "If savers are looking for more flexibility from their savings, an easy access account may be the best option."

Current best buys include Santander's Flexible ISA which pays 2.85% on a minimum investment of £1, and you can get access to your money whenever you want. Bear in mind, however, that this rate is only guaranteed for 12 months, so you may want to move your money at the end of this period. Transfers in from other ISAs are not permitted.

Alternatively, the Halifax ISA Direct Reward account pays 2.80%, again on a minimum investment of £1. You can earn a higher rate of 3.00% if you have a Halifax current account. The account allows unlimited withdrawals, but you need to keep a balance of at least £1 for the 12-month reward period. Transfers in are also accepted so if you have money in ISAs you invested in previous tax years that is no longer earning a decent return you can move it and benefit from a more competitive interest rate.

Tax-free savings are the winner

If you haven't yet used your ISA allowance and you are able to tie up your savings for a year or more, you should definitely opt for a fixed rate ISA over a fixed rate bond. Even though the headline rates of interest might be lower, your returns will still be higher because they are tax-free.

Remember, however, that with any fixed product, it is important that you are aware of when the rate expires, and you should transfer your money then if the account no longer looks competitive.

Please note: Any rates or deals mentioned in this article were available at the time of writing. Click on a highlighted product and apply direct. 

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