Savings accounts

Introductory bonus rates

It is also a good idea to understand the ways in which providers adapt their savings rates so that their accounts appear in the so called ‘best buy’ tables. These include using introductory bonus rates to bolster the interest rate over the short term, after which they revert to an inferior rate.

Introductory offers typically last for six to 12 months, which artificially boost the headline interest rate. However, once this ‘teaser’ rate expires, the interest rate will revert to an inferior rate.

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.

Introductory bonuses can also distort AERs (the annual equivalent rate) 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.

AERs on savings accounts

The AER is the official rate for savings accounts and uses the frequency of interest payments. It is designed to allow easy comparison across different savings accounts.

It will show what you would 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 is actually paid. The main thing to remember is that you need to compare like-with-like, AER or the gross rate.

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.

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 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 have a total of £121 saved.

This means your money grows quicker because you don't just earn interest on the money you originally saved, but you are also earning interest on the interest, and so 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 would have £300 in the bank at the end of 20 years. However, because of the interest on the interest you actually have £673.

Choosing a savings account

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 or 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 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.

You may have a large lump sum to deposit, if so, then 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, remember to watch out for those introductory bonuses. To ensure that you do not get caught out diarise when the bonus rate expires to remind yourself when you will need to shop around.

Protecting your savings – how much is covered?

Following the nationalisation of Northern Rock, Bradford & Bingley and the part nationalisation of RBS, the Government increased the protection for individual savers to £50,000 per lending institution. This means that you need to be careful when you are spreading your savings across different institutions that they do not have the same owner.

If, for example, you have savings of £40,000 with RBS, and £30,000 with Direct Line you will only be covered up to £50,000 in total as both are part of the same group. Check with your savings providers if you are in any doubt.