Are bonds better than ISAs?

Fixed rate bonds have long paid better interest rates than ISAs of equivalent terms, but why is that, and does it necessarily mean that fixed bonds are always the way to go? We investigate.

The Personal Savings Allowance (PSA) allows basic rate taxpayers to earn up to £1,000 in savings income tax-free annually (up to £500 for higher rate taxpayers). For some savers, this means they can use other types of savings accounts in addition to or instead of ISAs and still be tax efficient.

However, for those who have a substantial amount of savings – particularly higher rate taxpayers, who may more easily breach their PSA – fixed rate ISAs can still prove beneficial. This is because money held in an ISA and any resulting interest retains its tax-free status, no matter how much is accumulated over the years, so there is no tax bill to pay on any funds held in an ISA.

It starts with a legacy that originally ISAs were an easy, tax-efficient way to save. Providers could therefore offer lower rates in exchange for this benefit. After the PSA changes in April 2016, this benefit for ISAs was reduced, but even so, rates failed to improve and never equalised with fixed rate bonds. This may be because providers often have greater administration with ISAs (such as HMRC reporting), and so continue to offer lower rates.

However, the likeliest factor is the impact of new entrants into the fixed rate bond market from challenger and Sharia’a banking providers, which in turn is fuelling competition and rates. Many of these new entrants typically shy away from the ISA market due to the complexity involved, so the heightened competition in the bond market isn’t replicated among ISAs.

At first glance, fixed rate bonds seem better than ISAs by virtue of their higher rates, but this isn’t always the whole story. The overriding benefit of an ISA is its enduring tax-free status. You could accumulate a million-pound ISA fund and still not pay any tax on it, but the same can’t be said for fixed rate bonds (currently, you could save a maximum of £50,000 in the best five-year bond paying 2.00% before paying tax, or £25,000 if you’re a higher rate taxpayer, but any more and you’ll be liable for income tax on your savings).

For this reason, a combined approach would arguably be your best bet. This means putting a portion of your savings in an ISA to benefit from long-term tax-efficiency, while keeping some spare for a fixed rate bond to benefit from the best savings rates. That way you can get the best of both worlds.

Remember, too, there are specific forms of ISA available that could be suitable depending on your individual circumstances. This includes the Lifetime ISA, which is designed to help you save for either a first home or retirement, complete with a 25% Government bonus on top of anything you save up to £4,000 per year. There are also stocks and shares ISAs, which we discuss below, and Innovative Finance ISAs, which see your money lent to borrowers and businesses (a form of peer-to-peer lending) and typically offer higher rates than standard cash ISAs, though there’s more risk involved.

Another option could be putting some of your savings in Premium Bonds. Premium Bonds don’t pay interest, but instead offer the chance to win a monthly cash prize of between £25 and £1 million, with any prizes received being tax-free. They offer the same level of tax efficiency as ISAs, but because they don’t pay interest, there’s the chance that you may not see any returns at all – the current odds of winning are 34,500 to 1 for every £1 Bond held. NS&I say that the effective interest rate is 1%, which means if you have average luck, you can expect to receive prizes that equate to roughly 1% of your holdings. But there’s no guarantee.

Yet for some the chance to win a substantial prize could be too big an opportunity to pass up, so a mix and match approach may again be suitable. Premium Bonds can be particularly suited to higher earners looking to avoid paying savings tax – and the more Bonds you hold, the greater the likelihood of winning – with the fact that all money held is 100% backed by the Government being another plus point. For those who want guaranteed returns, Premium Bonds may not be suitable, but if you’re looking to diversify your savings holdings, they could be worth considering.

It’s important to note that the ISAs we’ve been discussing so far are cash ISAs, in which you save your money in cash and get a set interest rate in return. It’s these rates that are markedly lower than their fixed bond counterparts, but there could be an alternative in the form of stocks and shares ISAs.

Stocks and shares ISAs give you the chance to generate a much healthier return from your savings, because rather than saving your money in cash, you’re investing it in the stock market. Any returns are based on the performance of the funds you choose, rather than a clear-cut interest rate. This offers the potential for far greater gains, particularly if you invest over the long term, though the trade-off is that if your funds don’t perform well, you could end up with less than you put in.

There’s no guarantee with a stocks and shares ISA, unlike with a cash ISA, which is why they should only be considered by those who are comfortable with that level of risk. It’s worth seeking advice, too; if you’ve got more than £100,000 in savings and investments, you could take advantage of a free savings review from our preferred financial planners Kellands. Find out more here.  

It’s easy to compare ISAs and find the best fixed rate bonds using our comparison charts.