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Variable or fixed rate savings?

Saving | Savings Accounts

By Justin Modray, published 14 March 2011.
Helpful? 33

Will your cash grow faster in a variable or fixed rate savings account?

With the Bank of England Base Rate still anchored at 0.5% it takes a bit of effort to get a reasonable return on cash. And when interest rates do move it'll almost certainly be up, so it's little surprise to find fixed rates are currently higher than variable.

But if you can afford to tie up cash rather than leave it on instant access, is a fixed rate likely to end up the better bet?

Let's look at a comparison

To try and run some sort of comparison I've picked the 'best buy' rates (at the time of writing) for variable and fixed rate accounts, then looked at the total return assuming interest rates rise by 1% each year for the next 5 years. That is, a variable rate of 3% for year 1, 4% for year 2 and so on.

As fixed rate accounts normally pay out interest rather than offer a 'growth' option, I've assumed that interest is placed in the variable rate account until maturity and that the variable rate account remains 'best buy' throughout (in practice you'll probably have to shift to other 'best buy' accounts when the rate/bonus inevitably declines after a while).

1 year2 year3 year4 year5 year
Fixed Rate ('best buy') 3.45% 3.95% 4.20% 4.25% 5.00%
Value of £10,000 £10,345 £10,834 £11,388 £11,922 £12,955
Variable Rate (assumed) 3.00% 4.00% 5.00% 6.00% 7.00%
Value of £10,000 £10,300 £10,712 £11,248 £11,922 £12,757

As you can see, with the exception of a 4 year fixed rate (which ties with variable), the returns from the fixed rate accounts come out on top.

Is the comparison realistic?

Well, we don't know what will happen to interest rates over the next 5 years. But in my view the 1% increase each year I've assumed is probably over the top - more likely we'll see a lower overall rise during the next 5 years. So, if anything, the comparison is maybe overly generous to variable rates, making fixed rates look even more appealing.

Are fixed rate savings the best choice?

For modest savings we're probably not talking about a mega-bucks difference in the overall interest you might earn between fixed and variable accounts, especially on shorter term fixed rates and after tax. So you need to weigh up the extra potential interest against the loss of flexibility and access to your money. We all likely place a different price on this, so the answer will be quite personal.

But I think it's sensible to conclude that if you are happy tying up money then a fixed rate will probably leave you better off over the next few years.

Why I don't think interest rates will rise, by much

The Bank of England primarily uses interest rates to try and control inflation. If prices are rising because we're all spending lots of money (i.e. sellers can raise prices because of high demand) then raising interest rates is usually an effective antidote to inflation. High interest rates leave us with less money to spend (higher mortgage payments etc) and encourage more saving.

While inflation is high at the moment, it's not really been caused by us all spending too much - high oil and food prices are more to blame. If the Bank of England raises rates in the current climate it'll make little difference to inflation but risk a fall in consumer spending which in turn could push us back into recession. I don't think it can afford to take that risk for some time yet.

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