Savings: Interest rate cut on Premium Bonds, what are the alternatives?Premium Bonds, the ever popular tax-free savings account from National Savings & Investments (NS&I), got a little less attractive yesterday, with the news that less money will paid out in prizes from August onwards.

Premium Bonds are perhaps the most popular way of saving in the UK, with more than 22 million people holding them.

Unlike traditional savings accounts no interest is paid, but each £1 bond is entered into a monthly prize draw. Prizes are available from £5 to the £1 million jackpot and any winning are tax-free. The maximum amount of money which can be held in Premium Bonds is £30,000 per person.

Despite their popularity, the returns, when compared to an average savings account, are not that attractive. According to the Premium Bond Calculator on Martin Lewis’s Money Saving Expert website, an individual holding the maximum £30,000 of Premium Bonds for three years, stands to win approximately £1,000 in total. Equivalent to a 3% return; hardly attractive now and rates are about to get worse!

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The most competitive instant access Cash ISAs  (Individual Savings Accounts) currently pay a tax-free rate of interest of over 2% interest per year. Even the NS&I Direct ISA pays more than double the rate of return given by Premium Bonds!

The latest drop in the return Premium Bonds provide, might be enough for some loyal savers to cut their ties and consider other options, but what are the alternatives? Here are a five to consider:

1.    Cash ISAs

The £5,760 maximum you can pay into a Cash ISA each year is significantly less than £30,000 you could pay immediately into Premium Bonds. But, if the ISA allowance is used each year, it can build up into a healthy nest egg, well in excess of the maximum Premium Bond holding allowable, which of course also shelters interest from tax.

Despite interest rates plummeting over recent months, there is still a number of instant access Cash ISAs paying a better rate of return than Premium Bonds.

2.    Normal savings account

Even if you pay tax, the net rate of interest on a normal savings account, could be higher than the return you can expect from Premium Bonds.

If you are prepared to tie up your savings in a one year fixed rate bond and let’s face it most people who own Premium Bonds hold them for far longer than that, you can get a gross interest rate of around 2%.

After basic rate tax has been deducted, the rate is still well in excess of the expected return from Premium Bonds; it is even better for higher rate tax payers, although the difference is more marginal.

One thing is guaranteed though, if you save into Premium Bonds, Cash ISAs or any other savings account, you will lose money in real terms. None of these options pay enough interest to beat the current level of inflation; to do that you need to expose your savings to more risk.

3.    Peer to peer lending

Any money held with NS&I is 100% guaranteed, whilst money held in Cash ISAs, up to the £85,000 limit per person, per institution, is covered by the Financial Services Compensation Scheme. Therefore any diversion from these types of accounts is bound to increase risk, but with it could bring additional reward.

The concept of peer to peer lending isn’t complicated; it is simply the act of matching willing borrowers with willing lenders. However, as with any investment, the devil is in the detail and there is certainly more risk involved, for example borrowers could default.

The likes of Zopa have built in a number of safeguards to protect your savings and you can expect higher returns than from a normal savings account or indeed Premium Bonds. But you do need to accept the additional risks.

Read our recent article: Is peer to peer lending the answer to beating inflation? to learn more.

4.    Non FSCS protected bonds

As interest rates on traditional savings accounts have fallen, a range of alternatives fixed rate bonds have been launched.

Whilst these alternative bonds might look attractive, they do not benefit from FSCS protection; if the bank goes bankrupt you could lose all your savings.

One example is the fixed rate bonds offered by Agri Bank, which currently pay 3.35% for three years, 3.50% for four years and 3.60% for five years. Whilst these rates are well above the best alternatives from more traditional savings accounts, the lack of FSCS protection increases the risk significantly.

5.    Invest

The first four ideas were all deposit based solutions, both with and without FSCS protection.

The traditional alternative to savings has always been investing, generally through a portfolio of diversified funds, giving exposure to asset classes such as equities (stocks and shares), corporate bonds, gilts, commercial property and so on.

To consider investing you need to be prepared to tie up your capital for at least five years, be prepared to accept a degree of risk, and accept that the value of your investment will fall as well as rise.

There are of course tax-efficient ‘wrappers’ such as ISAs you can use and for those people who invest wisely, perhaps after taking Independent Financial Advice, the rewards can outweigh the risks and provide that elusive ‘real return’.

But remember, investing is very different to your Premium Bonds.

Is it time to ditch Premium Bonds?

Without knowing more about your own circumstances, goals and objectives, we can’t advise anyone in short article such as this to ditch an investment.

Premium Bonds still have their inbuilt tax-efficiency and security going for them, but the rate of return, unless of course you are very lucky, is frankly paltry.

In our opinion, unless you have a strong sentimental tie to your Premium Bonds, and we accept some people do, yesterday’s announcement cutting the prize rate should be the trigger to consider other options.

Do you want to consider alternatives to Premium Bonds?

Our team of Independent Financial Advisers are experienced in advising clients on their saving and investment options.

If you would like advice on whether you should keep your Premium Bonds, call one of our IFAs  today on 0115 933 8433, alternatively enquire online or email info@investmentsense.co.uk

The all-important small print

You should remember that the value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.