If you are saving up for something special – such as a holiday, a car or even a house, or you just have money to spare at the end of each month – it makes sense to find the best home for it, so it can work hard and make you the best return.

Review your finances first: getting rid of debt is the best way to save

Before you start to look for a savings account, you should take a good look at your finances in general. The first thing you should do, if you have any money to spare, is clear your debts. You are unlikely to be able to find a savings account that will beat the interest you pay on long-term debt, particularly as interest on most savings accounts is taxed.

Therefore, the best thing you can do with any money left over at the end of the month is to put it towards your most expensive debt. That is probably your credit card balance, unless you are on a special 0% deal.

You could also consider putting surplus cash towards overpayments on your mortgage, or, if that is not permitted, setting money aside to make a capital repayment when the mortgage terms and conditions allow.

How much access do you need to your cash?

Your next job when choosing a savings account is to decide how much access you need to your money. Are you saving for a long-term project, such as a dream holiday in a year or two, or are you trying to build up an emergency fund?

If you might need to dip into it at short notice, go for an instant access account, but if you can tie your money up for a while you may be able to get a higher rate by going for a fixed-term account or a notice account.

Two accounts?

If funds allow, you might actually opt for two accounts – one for long-term saving, building up a nest egg so that you don’t have to rely on borrowing for big purchases – and another for your rainy day money. While you want to get the best interest rate possible, there is no point tying yourself in to an inflexible savings scheme and being forced to borrow at a higher rate to do essential repairs or pay unexpected bills.

What is saving

Let’s make clear what “saving” actually means.

Saving is putting your money into a deposit account where it gathers interest. The amount you pay into your account won’t ever go down, and you will obtain interest on it, making it grow.

Saving is not the same as investing

While people do use the words interchangeably – perhaps talking about “investing in a building society” – saving is not actually the same as investing. Investing involves taking some degree of risk. When you withdraw the money you have invested, you might, if you are lucky, get a lot more money back than you would from a savings account. But you also run the risk of getting back less, and, in the worst case, you might not even get back what you put in.

The effects of inflation

The reason that people are prepared to take a risk with their money is because they seek growth, and one of the reasons for this is the effect of inflation.

The problem is that, if the interest rate you are receiving on your savings is not more than, or at least equal to, the rate of inflation, the buying power of your money will fall. So, if you pay £1,000 into your account today, in 10 years’ time that same £1,000 will buy, perhaps, only three-quarters of the goods it would buy today.

For example, if inflation runs at just 2.5% a year for the next 10 years, the purchasing power of £1,000 will have fallen to £776 compared with today. And remember that, because most of the interest you receive is liable to income tax, your money has to work even harder just to keep pace with inflation.

Saving is for those who do not want to take risk

However, many people do not want to take any risk with their money, particularly if they are saving for the short term. Savings are not subject to risk as investments are. The only risks you run are the effects of inflation (see above) and the remote risk of a default by the bank. You can, therefore, consider your savings to be “guaranteed” up to a certain point.

Banks and building societies operating in Britain with accounts available to the public are regulated by the Financial Services Authority, which makes them obey strict rules when looking after your money. Additionally, they are members of the Financial Services Compensation Scheme, which means that, in the extremely unlikely event of a default by a bank or building society, you would get your money back, up to a ceiling of £35,000

How interest rates work

To get the best rate on your cash, you need to understand how interest rates are stated and how to compare like with like. You will see three or maybe even four rates quoted for most savings accounts.

The gross rate is the rate of interest payable before deduction of income tax as required by law.

The net rate is the rate that you will receive in your account after income tax has been deducted (currently 20%). This is the rate that most people get, unless they have registered to have interest paid without tax taken off.

Higher rate taxpayers who pay at the rate of 40% must pay a further 20% by declaring the interest they have received on their self-assessment forms, and then paying the amount due to the taxman after the end of the tax year.

The annual equivalent rate (AER) is a notional rate which illustrates what the gross interest rate would be if interest was paid and added to the account annually. The AER helps you to compare rates that run over uneven periods or include a special bonus.

Monthly interest AER. If you elect to have your interest paid monthly instead of at the end of each year, the interest you actually receive will be less than the annual rate, because the interest will not be rolling up, earning “interest on interest”. The AER for monthly interest will help you to compare rates in these circumstances.

Types of savings account

Instant access

The simplest are bank and building society accounts operated with a cash machine card or a passbook. You can often open an account with as little as £1 and pay money in and take it out whenever you like. The price for convenience is that you will probably receive a non-competitive rate of interest, and this rate can fluctuate up and down depending on the Bank of England base rate and investment conditions.

Variants on instant access accounts are so-called Direct Access accounts. These can be operated over the phone or via the internet. You usually need to link the account to a bank account, and withdrawals are made by transfer into this account. While you can withdraw your money on demand, it may take a day or two for you to get your cash in your hand.

Because of the savings in overheads that can be made by the banks in running these accounts via call centres rather than branches, you will get a better rate of interest with a direct access account than on a passbook account. Some direct access accounts will also let you withdraw your money from a cash machine with a card.

Notice accounts

You can sometimes get a higher rate if you are prepared to give notice on your account. However, interest rates and marketing policies by the various savings institutions chop and change all the time, so don’t assume that giving notice will necessarily net you a significant boost in terms of interest. You are more likely to get a better return by switching from a branch to a telephone or internet account than putting your money in a notice account.

Fixed-term accounts

Fixed rate

With these accounts, sometimes called “bonds”, you put your money on deposit for a fixed term, usually one or two years. The rate will be fixed at the outset and stays the same for the whole period, no matter what happens to the Bank of England base rate. The terms of the account will usually state that you may not make any withdrawals during the fixed-rate term, except in the case of the death of the holder. Some longer-term accounts will let you take your money out in an emergency or at a certain point in the term, although in that case you will probably have to pay a severe penalty.

Tracker

Tracker bonds work in a similar way to fixed-rate bonds, but the interest rate will be pegged to an external indicator – usually the Bank of England base rate. A tracker bond will typically have an interest rate set at a certain number of percentage points over base rate and then mimic base rate movements from there on. So, if base rate rises – or indeed falls – by 0.25% during the term of the bond, the interest rate on the bond goes up – or drops – by the same amount.

Regular saver

If you can afford to put by a little each month on a regular basis, a regular savings account is well worth having. There are some astonishingly good rates available for regular savers, often linked to the individual banks’ own current accounts. But beware: on some accounts with higher rates you are often not able to withdraw from the account for a year, and with those that do let you make withdrawals you will pay a hefty penalty.

Bonus savers

Some regular saving accounts are designed around a bonus system (see Bonus accounts below). They pay a low basic rate, but you are paid a bonus if you make fewer than a certain number of withdrawals in a year. You are getting the best of both worlds here, if you think there is a chance you might need to get access to your cash. The rules allow withdrawals, but if you are lucky enough not to need to get your money back during the term of the account, you will get a bonus at the end of it.

Other bonus accounts

Bonuses work well with regular savings accounts (see above), but do take care with headline-grabbing special offers on other accounts. Often you will see accounts topping best-buy tables with a little asterisk next to the rate, saying something like “includes 0.5% bonus for the first six months”.

If you are planning to save over this period, that’s fine – or if you think you will remember to move your money when the bonus period is up. However, the banks and building societies rely on your inertia to leave the account in situ. So, if you think you might not get round to taking action when the time comes, look for an account with a good overall rate and not necessarily one that’s reaching for the stars.

Accounts for special age groups

Many banks and building societies offer special terms for specified age groups, such as children and pensioners. See our separate sections on Saving for Children and Silver and Gold for older savers.

Loyalty accounts

Banks and particularly building societies often offer preferential rates to people with existing accounts, or put savers on to a better rate once they have held their accounts for a certain amount of time.

These accounts tend to come and go, and the so-called loyalty bonds are usually on offer for a short period, so have to be snapped up quickly.

More information:

The Financial Services Authority http://www.fsa.gov.uk/
The Financial Services Compensation Scheme http://www.fscs.org.uk/

CashQuestions Guide to Tax-Free Savings 

CashQuestions Guide to Saving for Children 

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