MAKING BANK/BUILDING SOCIETY DEPOSITS

Deposit accounts are designed for money to be left alone for a period, in contrast to current accounts which are intended for frequent transactions.

Whilst deposits and withdrawals are easy, these accounts do not have the facilities of a current account such as cheque books. A higher rate of interest is therefore paid.

A deposit account is a useful back-up to a current account, with easy transfer from one to the other. As well as being the best place for your cash reserve, the deposit account can also be the first port for your savings, especially for short-term objectives, such as a holiday or Christmas.

You need to keep a record of the different amounts you are saving, but there is an advantage in placing them all in the same account, as interest rates may increase with the amount deposited.

Understanding interest rates

Interest rates on deposit accounts may be fixed or variable but the capital value does not change.

There may be higher rates available for notice accounts, where there is a period of notice before withdrawal or a penalty for earlier withdrawal. Thirty days is a common period but there are accounts available for 60 or 90 days, or even longer. More planning is necessary to avoid penalties and these are not suitable for your emergency fund.

Another important factor is the amount on deposit. Rates frequently increase at £2,000, £10,000 and £25,000. There may be a minimum balance.

The frequency of interest payments varies, so rates are compared by using the annual equivalent rate (AER), which takes account of the timing of interest payments.

Watch for introductory rates, sometimes called a bonus. These last for a limited period, usually only six months (to attract new investors) and it is the subsequent rate which matters.

The final point on interest rates is that it is the after-tax rate which matters for you, so your marginal income tax rate (the highest rate you pay) is a critical factor.

Choosing an account

There is a wide choice of account at all levels of deposit and notice period and the situation is constantly changing, so what is best for you today might be different next month.

However, when interest rates are generally low, unless you are making a substantial deposit the difference will not be great and it is not worth the bother (and loss of interest) of changing accounts for a small increase.

One thing to watch out for, though, is the closure of an account to new entrants, which tends to happen when it has become less attractive and the provider has introduced a new account. They are not bound to notify account holders, although complaints about this have caused some to do so.

Therefore it is wise to check the current rate on your account and compare it with the competition. Comparable rates can be found in newspapers and in Which? and other money magazines.

Using postal and Internet accounts

A number of banks and building societies have postal and/or Internet accounts. The advantage is that interest rates may be slightly higher because the expense of maintaining branches is avoided.

The disadvantage for postal accounts is the delay in transactions, particularly when making withdrawals.

However, return by post is generally quick (except at Christmas-time) because they aim to reply the same day, using first-class post.

In the case of Internet accounts, transfers in and out are usually from and to a nominated account (such as your current account), which means there is a two-stage operation if you wish to transfer the money somewhere else.

INVESTING IN NATIONAL SAVINGS

National Savings (NS) are investment products provided by the government and are therefore a way for the government to borrow from the public. They are mainly longer-term investments. There are minimum and maximum investment amounts for each.

In every case the capital value remains intact. Interest rates may be variable or fixed for the period of investment. In the latter case, as general interest rates change, the current issue may be closed and a new issue opened at a higher or lower rate. (The word ‘issue’ is used to describe the product currently available in each category.)

Interest may be tax-free, taxable (paid gross) or taxed (deducted at source). In some cases interest is paid out; in others it is kept in till maturity.

Some interest rates are not reasonably competitive at present. Current rates and investment limits are available from post offices, in newspapers, on Ceefax/Telefax or on the Internet. Present rates are shown in Figure 8.

Where there are relatively low limits on investment, such as for savings certificates (£10,000), two people, in addition to each investing the full amount, can hold a further investment in trust for each other, thus doubling their joint holding to £40,000.

It is also possible to create an income (albeit delayed) from a product which does not pay out interest, such as Savings Certificates, by buying a series of certificates of the minimum investment (in this case £100). If they are

purchased in successive months, then three or five years later they will be cashable in successive months.

There is a National Savings Investment Guide which will help you choose between the wide range of products. This, and separate leaflets about each product, are available at post offices.

Savings certificates

There are two kinds – those which pay a fixed rate of interest and those which are index-linked, i.e. interest is at a fixed rate above inflation (as measured by the retail price index). There are also two investment periods, two years and five years.

The limits to investment for the current issue are £100 minimum and £10,000 maximum. In all cases certificates must be held for the full period to obtain the full interest rate but they can be cashed in earlier at lower rates.

Interest is guaranteed for the period, is kept in and is tax free, making such certificates of particular interest to higher-rate taxpayers.

On reaching maturity, certificates need to be cashed in or transferred to the current issue (which doesn’t breach the limit); the money can be left in but the rate of interest for matured fixed-interest certificates falls to the general extension rate (2.01%), a much lower rate which applies to all NS products which have passed the initial investment period.

Children’s bonus bonds

These can be bought in units of £25 for a child (under 16), who can hold up to £1,000 in each issue until reaching the age of 21. Interest is guaranteed for five years, is kept in and is tax free.

Pensioners’ bonds

These are only available to the over-60s. There are three periods for investment – one, two and five years. Interest is guaranteed for the period, is paid out monthly and is taxable, for which reason they are mainly of interest to the non-taxpayer.

The minimum investment is £500 and the maximum £1 million for all issues.

Capital can be withdrawn before the period is up, but two months’ notice is required and no interest is paid for that period. Alternatively, immediate withdrawal is possible, subject to the loss of 90 days’ interest.

Withdrawal after the period is up must be requested within two weeks of the expiry date; otherwise another period of two or five years starts. Reminders are sent.

Capital bonds

The term is five years and interest is guaranteed. The minimum investment is £100 and maximum £250,000.

In this case gross interest is added to the bond annually and is not paid out till maturity, but is then taxable. (An annual statement is sent for income tax purposes.) Early withdrawal is possible but there is an interest penalty.

These may be of interest to higher-rate taxpayers who already have the full allowance of savings certificates and do not need regular income.

Income bonds

These are similar to capital bonds but interest is paid out monthly, so they are of more interest to those who require a regular income. However, interest is variable and is taxable.

Three months’ notice is required for withdrawals, although immediate withdrawal is possible subject to the loss of 90 days’ interest.

The minimum investment is £500 and the maximum £250,000.

Fixed-rate savings bonds

These bonds earn a fixed rate of interest over set periods of time – six months, one year or two years. Rates are tiered so the more you invest and/or the longer the period, the higher the rate.

Interest is guaranteed for the period, can be left in or taken out monthly or annually (at slightly lower rates) and tax is deducted. There is an interest penalty for cashing in early.

The minimum investment is £500 and the maximum £1 million.

Investment account

This is more like a bank deposit account than the other NS products and is convenient for small savers. You can deposit a minimum of £20 at a time. One month’s notice is required for withdrawals but these can be immediate, subject to the loss of one month’s interest. Deposits and withdrawals are made at post offices.

Interest is taxable and can be taken out or left in. Interest rates increase with the amount deposited, in seven bands ranging from under £500 to over £50,000. Current rates are lower than the best building society rates.

Ordinary account

This is like a bank current account and is also convenient for small savers. You can deposit as little as £10 at a time. However, there are no cheque books or other facilities such as standing orders.

The interest rate is low but is tax free for amounts of up to £70 a year.

Deposits and withdrawals are made at post offices. Up to £100 can be withdrawn on demand; larger amounts take a few days.

Premium bonds

This is the only form of gambling where you do not lose the stake! An average return on a large investment can be expected in the long run of over 3% and of course there is the chance of a big win. On the other hand, with only a small investment you can go on for years without winning any prize.

The minimum purchase is £100 and the maximum holding is £20,000. The top monthly prize is £1 million and there are many prizes of lower amounts. Winnings are tax-free.

All investors (and particularly higher-rate taxpayers) should consider putting some money into premium bonds.

BUYING GILTS

Gilts are British government fixed-interest stocks, described as gilt-edged (gilts for short) as they are considered to be supremely safe. The most important factors are the interest rate and the redemption (repayment) date. There are a few stocks which have no redemption date.

The interest rate is based on the face value (the issue value) of each stock and is usually set at the market rate when the stock is issued. The percentage rate on the face value is called the coupon.

Interest is fixed for each stock, or in some cases is index-linked, i.e. expressed as a fixed percentage above the retail price index.

Redemption is usually set between two dates a few years apart, leaving the government some choice. The face value is repaid on redemption, indexed in the case of index-linked stocks. There are a few old issues which are irredeemable; they are called undated stocks.

Market price

This fluctuates in accordance with the relationship between current interest rates and the set rate on the stock. However, the length of time to redemption also influences the market price, bringing it nearer the face value as the redemption date approaches.

Another important factor affecting the price movement of gilts is that short-term interest rates tend to be more volatile than longer-term rates.

The price also takes into account the timing of interest payments on a stock. The price includes interest from the last payment date until the trading date (cum interest) but from a specified date the seller keeps the next interest payment and the price falls accordingly. (The stock is then described as ex interest.)

When interest rates are low, stocks which carry a higher rate of interest on the issue value will be priced above that value and so (other things being equal) the price will fall over the period to redemption.

Yield

The yield (interest as a percentage of current market price) is expressed in two ways – interest only and redemption, the latter also taking into account the difference between the current price and the redemption value, allowing for the time to redemption.

Interest payment

Interest is paid half-yearly and is taxable (capital gains are not taxable). It is paid gross i.e. before tax, although you can elect for it to be paid net of tax, except in the case of stock bought through the Bank of England (see below).

Buying and selling gilts

Gilts are traded on the Stock Exchange and form by far the largest value of dealings there. They are grouped into various categories:

• redemption less than five years away (shorts);
• redemption between five and ten years away;
• redemption between ten and 15 years away;
• redemption over 15 years away;
• undated (no redemption date); and
• index-linked.

There is another way for small investors to buy and sell - through the Bank of England Brokerage Service. Most stocks are included in it, but not all.

Purchases and sales are made by completing and posting a form, which can be obtained at any post office, together with an explanatory leaflet which lists the available stocks. The cost of dealing is lower than through a stockbroker.

Dealing is slower this way and you cannot set limits, so it is slightly more risky, but prices would only change significantly if there were to be a change (or expected change) in interest rates.

New gilt issues are made by auction, which has the advantage that there is no commission or spread (the difference between buying and selling prices). Fifty per cent of the value must be put up in advance.

The competitive auction is not suitable for individuals but you can bid on a non-competitive basis, by which you will receive the stock you have bid for (possibly scaled down if the bids exceed the issue amount) at the average price bid by the experts.

There is a mailing list for new issues, which you can get on to by contacting the Bank of England – ring (020) 7601 4878.

Choosing a gilt

Your tax position is important. Higher rate taxpayers should consider gilts with an interest rate lower than the current market rate because some of the redemption yield is capital growth which is not taxable.

Non-taxpayers should go for those with a high coupon rate with a price above par because of the relatively high interest yield.

Basic rate taxpayers are usually recommended to avoid gilts with a current market price above par because the capital loss to maturity will probably not be fully offset by the taxed income.

Gilt strips

Only recently introduced, strips divide a gilt into separate parts, one for each interest payment (a coupon strip) and one for the repayment value (a principal strip).

The attraction is the certainty regarding repayment because the principal strip is bought at a discount and the subsequent gain is guaranteed. The disadvantage is that the capital gain is treated as income in the year it is sold or redeemed.

Principal strips can be useful when investing for a specific purpose, particularly if protected from income tax in an ISA (See Chapter 7).