Savings account Guides

Is it worth getting a cash ISA?

Updated: Wednesday 11 April, 2012

By Martin Fagan

Falling interest rates and soaring inflation means finding a savings account that beats inflation is getting harder. But what about a cash ISA - Is this the answer to savers’ prayers? We take a look

The fall of the Bank of England base rate in March 2009 to a historic low of 0.5% has been a reason for mortgage holders to rejoice and savers to wail and gnash their collective teeth. Low mortgage rates mean lower savings rates and those savers seeking a high return on their money are not only looking for a savings account paying the highest rate, but also a rate that beats inflation.

Currently, the economic factors of low Bank of England base rates (0.5%) and high inflation (4.5% in August 2011) have created a toxic environment in which the spending power of money saved is eroded by inflation and the erosion isn’t compensated by returns on the savings.

How inflation erodes the spending power of your savings

For example, if in September 2006 you’d stashed £1,000 under your mattress, inflation (at 2.3%) would have reduced its spending power to £900.90 in August 2011. Had you put it in a savings account in September 2006, at 3.5% a year, you’d have made £190.94 in interest, so you’d be £94.84 up on inflation. However, when you’ve paid 20% on your interest (£38.19), you’re only £56.65 ahead of inflation.

But at least that’s a positive return on your savings. The problem starts when the annual rate of inflation is higher than the annual rate of return on your savings (minus the tax). As we’ve seen, inflation is currently 4.5% and the average rate of interest paid on no-notice savings accounts is 3.1% (source: Moneyfacts).

At those rates, over a year, after inflation your £1,000 would be worth £955 and a savings account would pay only £24.80 (gross interest of £31 minus 20% tax). So you’d have lost £45 of spending power to inflation, offset by £24.80 gained in net interest, but would still be £20.20 down over the year.

Cash ISAs mean receiving interest tax-free

The pitiful rates paid on some savings accounts are further denuded by having to pay 20% of any interest earned in tax to the exchequerso the real rate of return on an account paying 3.1% gross is actually only 2.48% after tax (net).

However, one of the advantages of cash individual savings accounts (ISAs) is you receive the interest tax-free, so the rate of return the account is paying is the one you actually get. Also, like a savings account, the longer you’re willing to leave your money in the account, the higher the interest rate the bank will pay.

According to Moneyfacts, the current highest rate on fixed-rate cash ISAs (which usually require you to leave your money alone for at least 12 months) is 3.3%, whereas the highest rate on a standard cash ISA (instant access) is currently 3%.

With an ISA, you do get the chance to invest in accounts that are linked to the stock market. Theoretically, these could give you better returns as, historically in the medium to long-term (five years and over), the stock market outperforms cash. However, in the short-term you could lose money - in the six weeks between the start of July and the middle of August 2011, the FTSE 100 lost 16% of its value.

But, had you invested your ISA money in Legal & General’s UK Alpha fund three years’ ago, your return would have been 84%, or a rough average of 28% a year. Had you invested your £1,000 in the Virgin FTSE All Share Tracker, your three-year return would have been 11%, or a rough average of 3.6% a year, which is the equivalent return of a bog-standard cash ISA, but carries a lot more risk.

To see in more detail how cash ISAs differ from stock market ISAs, check out our cash ISA v share ISA guide.

Savers are better off with a cash ISA

If you have money you’re looking to save and don’t want to risk stashing it under that loose floorboard in the spare bedroom, a bank or building society is the most likely option. But if the best available rate on a conventional savings account is identical to the best rate paid on a cash ISA, go for the ISA, because its tax-free status means you’re 20% up on the deal before you start.

For the current tax year 2012/13, which ends on 5 April 2013, you can invest up to £5,640 in a cash ISA. But, before deciding which cash ISA is right for you, be aware of the sneaky little tricks financial institutions sometimes pull to sweeten the deal in their favour.

When it comes down the nitty gritty - the interest rate - best buy tables offer invaluable assistance, but even armed with these you can be caught out. Some providers do the old trick of luring people in with a high headline rate that, once they’ve attracted enough business, they then cut back and hope no one notices. So, always check the rate your ISA is paying is the one you signed up for.

Another common trick that allows ISA providers to bump up a rate and secure the top spot in a best buy table is the bonus. Providers use bonus rates to entice you into opening your ISA account with them, but the bonuses are short-term. You may get the higher rates for a year (some providers only offer them for six months) and, at the end of that time, your rates could be drastically reduced. So check if the rate you’re getting includes a bonus or not.

Look before you leap

To help you evaluate all the cash ISAs marketed by the different providers, look at the annual equivalent rate (AER). This is a notional rate showing the actual interest rate you would receive if you held the ISA for 12 months and gives you a clearer picture of the return than the headline rate because it factors in costs and fees.

The other little trick is that the offered rate only applies if you invest a significant chunk - or all - of the annual limit of £5,640 as a lump sum. Don’t assume that cash ISAs opened with £1 will pay the top rate. And even if you weigh in with a significantly large lump sum, the top rate will only apply if you leave your cash undisturbed for 12 months.

A final note - many finance gurus, from Alvin Hall to most good independent financial advisers (IFAs), always recommend squirreling away three months’ net salary in case of emergencies. A cash ISA is as good a place to stash this cash than anywhere else.

To learn more about cash ISAs and how to choose the best one for your financial circumstances, check out our cash ISAs guide.