Is it time to dump your Premium Bonds?
It’s the UK’s biggest savings product by a mile – over 21 million people have over £60 billion in premium bonds. Yet according to our Money Saving Expert Martin Lewis, changes are coming that mean millions should dump them…
1. The basics. How do they work?
Premium bonds are a savings account where the interest is determined by a monthly prize draw. Each £1 you have is entered in the draw and you can win anything from £25 to £1,000,000. Many people love premium bonds and feel a real excitement at the draw, the problem is, do they pay enough (especially with the changes that are afoot)?
2. Premium bond prizes are tax-free but now so are most savings
This used to be a big boon, but since the launch of the personal savings allowance (PSA) on 6 April all savings interest has been paid tax-free. And you only need to pay tax if you're a basic 20% rate taxpayer earning over £1,000 interest a year (higher 40% rate £500, additional-rate get no allowance). So premium bonds’ tax-free status isn’t a biggie for most.
For those who will pay tax, there is a decent advantage of premium bonds, as prizes do not count towards the PSA, so it’s almost an extra allowance in its own right.
3. The rate is being cut but you won’t win that much anyway
The current prize rate is 1.35%, but it’s being cut to 1.25% in June. This in itself is far less than many of the top places to save such as the Santander 123 bank account, which pays 3% on up to £20,000, or Club Lloyds at 5% on up to £5,000.
However, in fact you’re likely to win less than that. If you think about it, a 1.35% payout means that for every £100 paid in to bonds, on average £1.35 a year is paid out – yet in practice this is impossible, as the smallest prize is £25. In fact if 20 people each had £100 invested, for one to win £25-plus, the remaining 19 would have to win nothing.
Even if you line up everyone with £1,000 worth of premium bonds in order of their year’s winnings, you’d find the person halfway along would have won… not a penny! In fact, you’d need to walk past almost two-thirds of the line until you hit the first £25 winner.
And it’s this ‘the person halfway along’ measure that is a far better display of what you’d win. It’s called the median average. You can use Martin’s ‘premium bond win predictor’ to see what you’re likely to win.
4. They used to be the only truly safe way to save…
Premium bonds are run by Government-owned NS&I, so they're 100% safe. But now all UK-regulated savings are protected by the Financial Services Compensation Scheme up to £75,000, and the premium bonds max is £50,000, so the advantage here is diminished.
5. If you’ve average luck you’re far better off putting the money in a savings account
If you won’t ever earn over the PSA then all your interest is tax-free anyway. So compared with the prize fund rate of 1.25% (from June) other top savings accounts win. The top easy-access account is 1.3% with Coventry BS or its ISA has the top rate of 1.4%. In fact the chance of premium bonds beating these if you have £1,000 saved is 37% or 22% if you have the full £50k saved.
And put it against the top high-interest current accounts and premium bonds are far worse. With £20,000 in Santander 123 you'd earn £590 a year in interest; the chances of premium bonds beating that is less than one in 40. So overall the summary is, if your savings are tax-free, as most people’s are, unless you’re extremely lucky, premium bonds will earn less than the best savings.
Yet of course if you will earn over the PSA, and have average luck, premium bonds become a far better bet. If you have £1,000 saved in premium bonds your chance of winning nothing is 63%.
6. Beware the powerful psychological sell of premium bonds – that ‘interest’ is called ‘winning’
This lottery-effect hooks you into the unlikely dream of bagging a million-pound prize. I often hear excited comments such as: “My friend wins £25 every few months!” Yet someone with £10,000 worth of bonds should win £100+ a year – that’s £25 every few months. The same money in Santander savings would ‘win’ £300 a year, guaranteed.
Normally in finance there’s a risk premium: you should expect higher returns when there’s a higher risk. For some perverse reason, with premium bonds, people tend to be happy to earn less when there’s a risk.