Guide to Saving Accounts

Choosing a savings accounts

There is a huge range of savings accounts to choose from, so before depositing your money, decide what you want the account to do for you.

For instance, are you investing for the short or the long term? Do you want income or growth? Are you saving for yourself or someone else, such as a child? Are you an older investor? Are you a non-taxpayer? Do you want the interest paid gross?

All these considerations will affect which type of account is best for you. If you want a tax free account, consider using up your Cash ISA allowance of £3,600 in the tax year 2009-10 (£5,100 for the over 50s from 6 October 2009 and for everyone else from 6 April 2010).

If you are saving for a child, have you maximised usage of the Child Trust Fund into which you and other relatives of the child can save an extra £1,200 a year tax free?

If you have mopped up these tax free allowances, consider National Savings&Investment products, some of which are tax free. Others are taxable, but pay interest gross.

If you are prepared to tie up your money for a year or more, a fixed interest rate account will normally pay a higher rate than an instant access account, but in either case, it is worth shopping around for the best rate.

If you have a large lump sum to deposit, some banks and building societies offer tiered rates of interest according to how much you save. That said, there are also some very competitive rates even on instant access accounts requiring a deposit of only £1, so be sure to shop around using the Defaqto Compare tool and Best Buy tables.

Online and telephone based accounts often pay higher rates than branch-based accounts which are more expensive for the bank or building society to administer.

If you can afford to save a regular amount each month for one year, a number of banks and building societies offer regular savings accounts paying very high rates of interest. But remember, you only get the high rate on the amount saved, which is typically £250 a month.

Finally, watch out for introductory bonuses. These are frequently used by banks and building societies to boost the headline rate of interest on their accounts for typically the first six to 12 months.

This propels their accounts into the all-important best buy tables, but after the bonus rate period expires, the account will revert to an inferior rate; so diarise when the bonus rate expires to remind yourself when you will need to shop around for a better rate.

Introductory bonus rates

These are being used increasingly by banks and building societies so that their accounts appear in the 'Best Buy' tables.

Introductory offers typically last for six to 12 months, which artificially boost the headline interest rate. However, once this ‘teaser’ rate expiresr, the interest rate will revert to an inferior rate. Financial institutions depend on savers’ ignorance or inertia to stay put.

Introductory bonuses can also distort AERs if the bonus is being paid for a period of less than a year, as the AER reflects the equivalent rate for the whole year.

If you don’t think you will remember to switch your savings at the end of the teaser rate period, it may be better to pick an account which has a record of paying consistently competitive rates, without the artificial booster of an introductory bonus.

Understanding interest rates

It is crucial to understand how compound interest works as this is the basis for all saving and borrowing.

For instance, if you have £100 in a savings account which pays 10% annual interest, after year one you will have £100, plus £10 interest (10% of £100), or a total of £110. After year two, you'll have earned another £10 interest (the interest on the original £100), plus a further £1 of interest earned on the £10 interest from the first year. So now you've a total of £121.

By year three, you'll be receiving interest on the interest from year two, and interest on the interest on the interest from year one; creating a compounding effect.

This means that your money grows more quickly because you don't just earn interest on the money you originally saved, but you are also earning interest on the interest, andso it goes on. This makes a big difference, because the longer you save, the greater the effect.

Let's say you put that money away for 20 years. If you were only earning the £10 a year, without the compounding, you'd have £300 in the bank at the end of 20 years. However because of the interest on the interest you actually have £673.

Interest on debt clocks up quickly, too. This is because you will be paying interest on the original capital, plus interest on the interest accrued.

So the longer you borrow, the quicker your debts mount up. Unfortunately, compound interest tends to have an even bigger impact on debt than on savings because interest rates on loans, credit cards and mortgages tend to be higher than savings rates.

For instance, if you borrow £1,000 at 10% over 20 years without making any repayments, your debt will grow to £6,700, whereas without compound interest, your debt would only be £3,000.

Tip:To work out roughly how quickly your debt will double, divide 72 by the annual interest rate. For instance, 72 divided by 7% equals 10.3 years. Although this is a useful rule of thumb, it is less accurate for rates over 20%.

Annual percentage rates

APR stands for the Annual Percentage Rate. When lenders calculate their APRs, they have to include both the cost of the borrowing and any compulsory associated fees, such as arrangement fees that are automatically included, so that you know the overall cost of your debt.

The fact that the APR must include all charges means that the figures you are shown can be a bit confusing. For instance, the interest rate might be 14% a year, but due to other charges the APR quoted is 17%.

Problems with the APR rate

Although it all sounds good so far, unfortunately there are a number of problems with APRs. Here are two of the main things to watch for.

APRs on personal loans

When you take out a personal loan, you can opt to take out payment protection insurance (PPI). Because PPI is not compulsory, the premium is not included in the APR calculation and therefore the APR does not truly reflect the cost of your loan if you take out PPI as well.

What looks like a cheap rate may be more expensive in reality than one which has a higher interest rate but with no PPI included. So a 5.7% APR loan with PPI could cost you more in practice, than a 7% APR loan with no PPI.

APRs on mortgages

The APR is meant to indicate the amount you will pay each year over the full term of the debt but it is only completely accurate if you hold a fixed rate mortgage for the full term. It is difficult to gauge exactly how much you will pay if you hold a mortgage for only a few years before switching.

This is because a mortgage APR is calculated by taking the total interest cost over the 25 year term of a mortgage, plus fees. This figure must be included prominently in mortgage adverts and documentation.

However, a mortgage quoting a 6.6% APR could be calculated on the basis of a fixed rate of 4.5% for two years, followed by a variable rate of 6.75% rate for the remainder of the term. The 6.6% represents the average cost if you were to continue with that mortgage for the full 25 year term and assumes that the variable rate remains at 6.6%, which is highly unlikely.

AERs on savings account

The AER or Annual Equivalent Rate is the official rate for savings accounts and takes account of the frequency of interest payments. It is designed to allow easy comparison across different savings accounts.

The AER is designed is to show what you'd get over a year if you put your money in the account and left it there. The alternative is the gross rate, which is the flat rate of interest that's actually paid. The main thing to remember is that you need to compare like with like, AER or the gross rate.

The effect of annual or monthly interest.

If interest is paid annually, then the annual gross rate and the AER should be the same. If interest is paid monthly, there is an additional compounding effect and the quoted AER will be slightly higher than the gross rate. This is because where the monthly interest is left in the account, this accrues interest too.

So, for example, an account paying 4.89% pa gross would have an AER of 4.89% where interest is paid annually and an AER of 5% where it is paid monthly.

A second confusion concerns the impact of introductory bonus interest rates on AERs. If a bonus is paid for the first six months only, the AER, which reflects the interest over the whole year, will be less than the gross rate which is quoted for the bonus period only.

If you're planning to move accounts when the bonus rate ends, then the AER is irrelevant, as you only need to know the interest rate during the bonus period.

So, in this case, you should compare gross rates and switch accounts accordingly, and be sure to take note of whether it's monthly or yearly interest.

Last updated 05 June 2009