Seven-step guide to savings bonds

When we put our money in a savings account we expect to be rewarded for our good behaviour with a growing savings pot. But, with inflation running at 2.8% and the average interest rate on an easy-access savings account a paltry 0.5%, most of our savings are shrinking in terms of purchasing power.

But, it doesn't have to be this way. If you're able to tie your money up for at least a year, a savings bond could pay you far more interest than a standard instant-access savings account.

Q: What is a savings bond?

A savings bond is a simple savings product offered by banks and building societies. In exchange for agreeing to tie up your money for a set period of time, typically between one and five years, you'll receive a higher interest rate than if you had opted for an instant-access savings account instead.

Most savings bonds pay a fixed rate of interest, so you know exactly what money you will get back when you hand your money over.

But there are also variable-rate products such as tracker bonds, which pay the Bank of England base interest rate plus a set percentage, and inflation-linked bonds, which pay inflation plus a set percentage. Depending on the bond, interest can be paid monthly, annually or rolled up and paid on maturity.

Q: How much interest do they pay?

Usually, the longer the period of time that you are prepared to lock your money away for, the higher the reward you will receive from the bank.

For example, while the top one-year bond from a traditional provider, Barclays Flexible Bond (Issue 19) pays 1.75%, the top three-year bond, from Virgin Money pays 3%.

Q: Do I need a lot of money to get these higher rates?

Not necessarily. While many providers set a minimum investment of £1,000 or more, some are far less choosy. As an example, the table-topping Virgin Money Three-Year Bond accepts minimum deposits of just £1. Just check the small print when shopping around.

Q: What if I need access to my money early?

This is where you can run into problems as there are some hefty penalties for accessing your money before the bond matures.

Banks charge this as they had expected to have your money for a set period and will have invested it accordingly.

What you'll pay varies, but in most cases you will lose a set amount of interest. 

Q: What happens to current rates if interest rates rise?

"If interest rates rise the rate on a fixed-rate bond becomes less attractive," says Anna Bowes, director of the comparison website

But rates would have to rise substantially before this is a problem. "When banks and building societies set the interest rates on their fixed-rate products they look at long-term interest rates. This means that future potential increases are already factored into your rate," she says.

Q: Is a tracker bond better than a fixed rate?

Tracker bonds pay interest based on the base rate plus a set percentage so your interest rate will rise as the base rate does.

However, they are only worth bothering with if you believe the base rate is going to rise as fixed-rate accounts tend to pay more interest.

Q: What is an inflation-linked bond?

Two very different products are known as inflation-linked bonds so it's important to know the difference. As well as fixed-term, deposit-based bonds that offer a return that is based on inflation, you can also buy inflation-linked corporate bonds, such as those issued by RBS and Tesco Bank.

"These are like any other corporate bond," explains Danny Cox, head of advice at Hargreaves Lansdown. "You buy them through a stockbroker and the return isn't guaranteed. If the company defaults your capital could be at risk."

It's also important not to confuse inflation-linked deposit-based bonds with their investment cousins, which are commonly linked to the return of one or more indices.

Although both are structured products, the rules vary as to what is covered under the Financial Services Compensation Scheme so always check with your provider before you sign on the dotted line.

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