Ever wondered why sometimes the top fixed rate ISAs pay a lower rate of interest than an equivalent fixed rate bond?
You should get out more! But the answer is at hand, and actually, it's surprisingly simple.
At present the top 5 year fixed rate bond pays 4.50% AER, while the best equivalent fixed rate ISA pays just 4.05% (based on an investment of £5,640).
In fact, if you look at the top 2, 3 and 4 year fixed rate ISAs, all have interest rates that are quite a bit less than the top bond rate available. The exception to the rule is 1 year fixed rate ISAs, where rates are currently on a par with 1 year bonds at 3.25%.
Of course, looking at top rates is only taking into account the extremes of the market. If we look at average rates though, bond and ISA rates aren't actually that far apart. In fact, ISA averages are higher!
We said at the beginning that the answer would be surprisingly simple!
The easy (and completely wrong) assumption to make is that fixed rate ISAs and equivalent fixed rate bonds should be paying the same rate. But while both pay a fixed rate of interest over a set term, there are subtle differences that make the markets very distinct.
If we look at the top fixed cash ISA rates for instance, and then look at that provider's top fixed rate bond, the rates differ surprisingly:
Far from offering equivalent bonds with higher interest rates, the top fixed rate ISA providers actually offer equivalent bonds that are lower! This illustrates the fact that the two markets are distinctly different, and that while a provider might be more competitive in one market, they may not necessarily choose to be so in another.
There are several reasons why the top interest rates on the top fixed rate ISAs are currently lower than on the top bonds:
The cash ISA and savings markets are different, so it would be wrong to think that interest rates should necessarily be the same.
The additional cost of offering a fixed rate ISA – including back systems and allowing a customer to transfer money out before the end of the term – means that an ISA is a more expensive product to run. This may well be why the make up of fixed rate ISA and fixed rate bond best buys are so different, as many top-paying bond providers have not entered the fixed ISA market.
Appetite for longer term bonds and ISAs is smaller than for shorter term options. Competition for 1 year fixed rate ISA customers is such that on average, they actually pay a higher interest rate than 1 year bonds – and have done so for the last 12 months.
Although interest rates on longer term ISAs are lower, it should be remembered that a fixed rate ISA is still likely to give a higher return than an equivalent bond, as the interest you receive is tax-free. So while the top 5 year fixed rate bond pays 4.50%, that rate is only 3.60% if you pay basic rate tax, or just 2.70% if you're a higher rate taxpayer. So the top 5 year fixed rate ISA at 4.05% is still one of the best savings rates you can get if you pay tax.
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Disclaimer: Information is correct as of the date of publication (shown at the top of this article). Any products featured may be withdrawn by their provider or changed at any time.
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