You could say that Premium Bonds are the most successful savings product in the UK. A well-recognised brand.
Officially, Premium Bonds are a government-backed tax-free savings product.
Unofficially, Premium Bonds are like lottery tickets masquerading as savings accounts.
Over 22 million people in the UK have money in Premium Bonds worth over £120 billion in total.
But as popular as they are, do they make financial sense for you? Or are your emotions dictating your desire to have Premium Bonds?
Premium Bonds: The financial thrill
The attachment to having Premium Bonds is linked to the emotions we display when buying a lottery ticket.
The temporary thrill of winning a multi-million-pound jackpot is worth the cost of a few quid.
We are saying to ourselves that we are willing to lose money for the possibility of gaining so much more. Think about when a lottery jackpot rolls over and over, suddenly we have this urge to be part of the action. A standard £10 million jackpot? No thanks, I’ll keep my £2. But £100 million? Now you’re talking. After all, it’s just a bit of fun, right?
Well the odd flutter here and there is fine, but there can be a dark side to anything that involves gambling with your money.
In fact, research has shown that lower income households spend more on the lottery than higher-earning households. The thrill almost becomes desperation.
So what does the lottery have to do with Premium Bonds?
Well Premium Bonds essentially enter you into a monthly prize draw. Every Bond is worth a £1 and each month thousands of prizes are given to Premium Bond holders. Anything from £25 to £1 million. You could win big, or you could win nothing.
Just like a lottery ticket, there is no guarantee of winning. It’s pure chance. The more Premium Bonds you have, the greater the chance of getting a prize. Just like when you buy more lottery tickets.
The difference between a typical lottery and Premium Bonds is that the value of your Bonds are protected. In fact, as a government-backed asset, they are the safest way to keep your capital (the value of the initial amount saved) safe.
So you’ve got a chance of winning £1 million and the money in those bonds is guaranteed to be returned to me whenever I need my cash back. Sounds a safe bet, doesn’t it?
Well you can stand to lose money in real terms. We’re talking about a couple of things:
Firstly, if you win nothing on Premium Bonds, you’re missing out on interest that you could have earned elsewhere. For instance, in a savings account or ISA.
Secondly, if the cash value of your Premium Bonds plus any winnings doesn’t keep up with inflation, you’re losing money.
Premium Bonds even give you a helping hand with the potential return you could get from your Premium Bonds.
It’s expressed as a percentage, so you can easily compare this to the interest you could earn elsewhere.
But the big difference is that it’s not guaranteed interest.
At the moment, the current prize rate is 4.00%. So, you might think that it’s very likely your prizes will be a minimum of 4% of the value of your Premium Bonds. This is false.
Logic says that the more Premium Bonds we have, the greater the chance of winning. And that’s true, just like it’s true when buying lottery tickets. But we need a higher reward for the cost of buying.
If I buy 1 lottery ticket for a £1 and win £5, it’s not a massive win but I’ve still made a real win.
If I buy 10 lottery tickets for £10 and win £5, I’ve still had a successful win on paper, but it’s a loss in real terms.
You may think having lots of Premium Bonds increases your chance of winning bigger prizes, but 4% of £50,000 is a much higher prize than 4% of £100. So your ‘in the money’ target is higher in the first place.
Premium Bonds have a unique allure not offered by any other savings product
Tax-Free way to save
Government-backed financial security
A chance to win £1 million
The trifecta of the above really hooks us in.
Now if you’re only putting in small amounts in Premium Bonds, you might not be concerned about losing a bit of interest, or that small amount being eroded by inflation. The mental benefits of a potentially lucrative future might be worth it.
But the more we have in Premium Bonds the more we should be asking ourselves:
1) Is this money safe in real terms? i.e. is it rising in value in line with inflation?
2) IF I do win any prizes, are those prizes more than the interest I would have received in a savings account or ISA?
Comparing the average prize rate of 4.00% against the interest rate on savings account would seem the obvious place to start. But you’re comparing apples with pears. One rate is guaranteed and the other isn’t.
The more money you have in Premium Bonds, the harder you’re going to be hit by inflation if those bonds fail to win you prizes at a rate that’s higher than inflation, which is currently around 3%.
Financially, it makes more sense to keep cash in a savings account or ISA earning a higher rate of interest. And this is achievable with rates as they are at the moment.
However you need to factor in any tax you could pay on interest earned. Remember any Premium Bond prizes are tax-free.
Cash in an ISA is tax-free. But cash in savings account could be taxed if the interest earned is over your Personal Allowance. And this is where higher rate or additional rate taxpayers may find Premium Bonds are a better option.
Let’s compare 3 options for holding £25,000:
1) Premium Bonds – average prize rate of 4% but no guarantees
2) Savings Account – The top account is paying around 4.75% at the moment
3) Cash ISA – The top account is paying around 5% at the moment.
The Cash ISA pays 5% gross interest, no tax deducted.
Savings accounts and tax position
As a basic rate taxpayer, you can earn £1000 in savings interest tax-free. Beyond this, interest is taxed at 20%. So £25,000 would pay £1,187 in gross interest. £187 is subject to 20% tax, so the net return is 4.6% factoring tax paid. A smidge under the advertised 4.75% rate.
As a higher rate taxpayer, you can earn £500 in savings interest tax-free. Beyond this, interest is taxed at 40%. So £25,000 would pay £1,187 in gross interest. £687 is subject to 40% tax, so the net return is 3.65% factoring tax paid.
As an additional rate taxpayer, you can’t earn any tax-free interest on your savings. So £25,000 would pay £1,187 gross, but as it’s all subject to tax, the net return is just 2.61%.
Check out my other post for the calculation to see if you would pay tax on savings.
So you can see that if you’re a higher rate or additional rate taxpayer, you may feel that you stand a higher chance of winning something on Premium Bonds that’s better than the post-tax interest you’d get in a savings account.
For anybody that wouldn’t pay tax on their savings elsewhere, then Premium Bonds don’t really make sense financially.
Consider your overall position with savings
If you’re being drawn to Premium Bonds through emotion, think about offsetting the potential of winning nothing by spreading your savings across various accounts.
Shop around for the best interest rates on savings accounts and ISAs.
Your overall cash position ideally wants to grow enough to protect you against inflation and protect the real value of your cash.
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