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Introduction to Saving


What is it?

Saving means tucking away spare cash somewhere safe so you can use it in future.

If you spend less than you earn, chances are you'll have some money to save. Saving is important as, short of a fortunate windfall, it's the only way most of us can accumulate a financial umbrella to cope with 'rainy days' (e.g. building/car repairs, unemployment etc.).

Saving money could mean anything from hiding it under your mattress to depositing it in a bank, but the key is that the cash is safe and that you can get your hands on it when needed. Yes, it is possible to 'invest' the money instead with the prospect of sexier returns; but you could lose out, especially if your 'rainy day' coincides with the investment plunging in value!


Interest

While storing cash in a jar or under a mattress might appeal to some, it's not a very good idea. The money won't grow unless you add more to it.

Much better to 'earn' some extra money, called 'Interest', in exchange for letting someone else use your cash while you don't need it (on the promise they'll return it to you when needed). Of course, you'd probably feel uncomfortable doing so with any old Tom, Dick or Harry, which is where banks and building societies come in.

Candid Fact If you put £100 under your mattress you would still have £100 25 years later.
If you had instead put the cash in a savings account with annual interest of 1.40% it would have grown to around £142 over the same period.

When you deposit money in a savings account with a bank or building society they can use this to lend to someone else, perhaps via a loan or mortgage. They profit by lending out your money out at a higher interest rate than the one they're paying you (the difference is known as the 'interest margin').

Interest, which is usually paid either monthly or annually, is quoted as an annual percentage rate before any tax is deducted (i.e. 'gross'). For example, an interest rate of 1.40% gross per annum (p.a.) means you'll receive £1.40 each year for every £100 held in your account.

Accounts that pay interest monthly usually pay a slightly lower rate of interest than a comparable account paying annual interest. This is due to compounding. However, fear not, banks and building societies must show both the actual interest rate and the Annual Equivalent Rate (AER), which factors in compounding.

Compound Interest The concept of compounding is really simple - you earn interest on the interest you've already received. For example, if you save £100 earning 1.40% (i.e. £1.40) interest in year 1, you'll benefit from interest on £101.40 in year 2 (i.e. £1.42 at 1.40%). Over time, compounding can make a very worthwhile difference to the return you enjoy on your savings.

So, if an account pays interest monthly at 1.40% p.a., how much is this really worth?

The interest paid each month will be 1/12 of 1.40%, i.e. 0.12%. If we start with £100 it will be worth £100.12 at the end of month 1 (£100 + 0.12%), £100.12 + 0.12% at the end of month 2 and so on. At the end of month 12 it would be worth £101.41, equal to a total annual return, or AER, of 1.41%.

Use our AER Calculator to check your own compounding examples.


Don't ignore debts!

Because banks and building societies profit by lending out your money at a higher interest rate than the one they're paying you, it's rare to earn a higher rate of interest on your savings than you'll be paying on your debts.

Candid Example A basic rate taxpayer putting £1,000 in a savings account paying 1.40% gross p.a. for 3 years would earn around £34 of interest after tax. If they also had a £1,000 debt on a credit card at an annual interest rate of 18.00%, they would have paid nearly £643 of interest after 3 years (ignoring minimum monthly payments). Saving at the expense of paying off the credit card could cost this individual around £609!

Therefore, if you have debts, it normally makes more sense to pay them off before you start saving. The only exceptions are if you have free/very low cost debts (such as 0% credit cards or a student loan) or the penalty for paying off the debt early is prohibitive.


Tax

The taxman gets everywhere and your savings are no exception.

Non TaxpayerStarting RateBasic RateHigher RateTop Rate

If you're a non-taxpayer then there's no tax to pay on your savings interest provided it doesn't tip your income above your personal income tax allowance. Make sure you give a completed HM Revenue & Customs (HMRC) form R85 to your bank or building society. This ensures you receive interest without tax being deducted, i.e. gross.

Use our Savings Tax Calculator to see how tax affects your savings income.

Candid Fact It's a fallacy that UK taxpayers don't have to pay tax on interest from offshore savings accounts. HMRC requires interest to be declared and tax paid via annual tax returns.

Some savings products, notably Cash NISAs and NS&I Certificates are tax-free, hence well worth a look for taxpayers.

Couples with savings should plan carefully if one partner is in a higher tax band than the other. The example below shows the financial benefit of holding savings in the name of the partner in the lower tax band.

Figures show interest, after tax, based on gross annual interest of £1,000
Mr Rich
(higher rate taxpayer)
Mrs Rich
(non-taxpayer)
Joint Account
Net Interest £600 £1,000 £800

Of course, moving savings between partners does involve an element of trust...but it can be a simple way of saving tax. Use our Couple's Savings Tax Calculator to discover whether moving savings between you and your partner could save tax.


Inflation

As a saver, inflation is your enemy. Rising prices of goods and services mean that your money will be worth less in future than today, so your savings could fall behind.

For example, if your savings account pays 1.40% after tax and inflation over the year is 1.40% then you're no better off. Worse still, there's a chance that over time the interest you receive on your savings is lower than inflation, especially if you're a taxpayer. This means you might actually be worse off in future!

We're currently in an unusual environment where inflation has, at times, been negative. This means your money would be worth more in future than today. Given this has been accompanied by a period of very low interest rates, there's sadly little reason for savers to rejoice. Also, because the biggest contributor to negative inflation (Retail price Index) has generally been lower mortgage interest rates, there's less impact on savers who've already paid off their mortgage.

Candid Fact Over the year to February 2014, the Retail Price Index rose by 2.7%. At this rate, the cost of goods and services will double over 26 years and 0 months

NS&I Index-Linked Certificates offer a way for savers to combat inflation, as they pay interest over and above the Retail Price Index (RPI). Returns are also tax-free.

Use ourSavings vs Inflation Calculator to see how your savings are faring against inflation.

Inflation is usually measured by an 'index', a number that reflects the cost of a typical basket of goods and services consumed by the public. For example, I could make my own basic index by calculating that my outgoings on food, fuel, utilities, mortgage and council tax this month are £1,000. Let's divide this by 10 and make my starting index 100. Suppose a year from now the identical monthly outgoings cost £1,050, then my index will be 105 and annual inflation 5%.

In the UK inflation is calculated each month by the Government's National Statistics department, which has two main measures:

Index What Does It Cover?
Retail Price Index (RPI) Over 650 items relating to Food, Alcohol, Tobacco, Housing, Fuel & Light, Household Goods & Services, Clothing, Personal Goods & Services, Motoring, Travel and Leisure.
Consumer Price Index (CPI) As per RPI but excludes Mortgage Interest, Council Tax, Home Insurance and Vehicle Tax.

RPI is the traditional measure and normally used when linking pensions, tax allowances and state benefits to inflation. [You might also come across RPIX, which is RPI excluding mortgage interest]

CPI is the measure used for the Government's inflation target (set at 2% in December 2003) and is comparable across other European countries as it's calculated using an agreed set of rules.

The proportion (or 'weighting') of each item is intended to reflect a typical consumer and revised once a year to keep it up to date. Of course few of us, if any, are 'average', so if you want a clearer idea of how inflation affects you could try using the National Statistics Personal Inflation Calculator.

The monthly inflation figures are published on a Tuesday, usually around the middle of the month.


How safe is my money?

After you've deposited your life's savings with a bank or building society, what's to stop them running off with your money?

In addition to confirming their responsibilities via a list of terms & conditions (i.e. the small print) when you open an account, the bank or building society should also be signed up to the Banking Code. This is basically an industry code of conduct that, amongst other things, says the bank/building society will act responsibly and take steps to safeguard your money.

In the unlikely event that the bank or building society is unable to repay your money (e.g. Landsbanki Icesave & Kaupthing Edge), they will be declared 'in default'. Provided the firm was authorised in the UK by the Financial Services Authority (FSA) you should then be eligible for some compensation under the Financial Services Compensation Scheme (FSCS). The FSCS is funded by the financial companies themselves, via annual 'levies' set via the FSA.

The FSCS protects 100% of the first £85,000 of your total deposits held with the financial institution in default. This is per person, so the figure effectively rises to £170,000 on a joint account. If a claim is triggered then you should receive compensation within 20 days.

Note: the FSCS cover applies to each financial institution registered with the FSA, so if one bank owns another the £85,000 limit applies to both collectively, NOT individually. Beware of this when opening accounts with different banks and building societies totalling more than £85,000.

It's common nowadays for foreign banks to market accounts in the UK. Are such accounts as safe as those with a UK bank? There's 2 scenarios:

Fully covered by FSCS
Provided the bank is regulated by the FSA and a member of the FSCS then you'll enjoy the same level of protection as a UK bank account, i.e. 100% of the first £85,000 of your total deposits.

Covered by home country compensation
If the foreign bank is operating the account under the European Economic Area (EEA) 'Passport' scheme then a €100,000 compensation limit will be provided by the bank's home country scheme. If the bank is not FSA regulated nor passporting under the EEA scheme it's just as if you had opened the account directly with the bank overseas and you'll need to check whether any local protection scheme applies.


Catches

If it looks too good to be true it almost certainly is! Some banks and building societies are very slick at marketing, using dazzling rates to tempt in new customers.

This is no crime in itself, in fact it can be a good thing provided you're aware of any potential catches. For example, the rate might include a temporary bonus that only lasts a few months. Typical catches to watch out for are highlighted on the pages in this section.


Savings jargon

Here's some of the more common savings jargon you might come across:

JargonMeaning
5% WithdrawalThe amount of your initial GIB investment that can be withdrawn each year with no tax liability at that time (it's calculated at maturity).
AERAnnual Equivalent Return. Shows the yearly interest you'd receive on your savings assuming interest is compounded over the year.
BACS PaymentA direct payment from one bank account to another using the Bankers' Automated Clearing Service. Usually takes three days to clear.
Bank of England Base RateThe rate of interest at which the Bank of England lends to ther banks, reviewed monthly. It's the Bank of England's key weapon for trying to influence the economy.
Cash (ATM) CardA card that allows you withdraw money from cash machines. Might also double up as a debit card.
CHAPS PaymentA direct payment from one bank account to another using the Clearing House Automated Payment System. Usually clears same day.
Cheque BookA paper based way of making a payment from your bank account to another.
Chidren's Bonus BondsA National Savings fixed term savings product for children. Interest is tax-free and fixed.
Cleared Balance Money that is in your bank account, cleared, and ready to use.
Compound InterestInterest earned on interest, e.g. if a savings account pays interest monthly you'll earn interest on interest paid in previous months.
CPIConsumer Price Index. A measure of UK inflation, excludes housing costs such as mortgage payments.
Debit CardAllows you to pay for items like a credit card, but the money is taken straight away from your bank account, just like a cheque.
Direct DebitsPayments made on a regular basis (e.g. bills) that are taken directly from your account on an agreed date.
ERNIEThe 'Electronic Random Number Indicator Equipment' used to draw the monthly prize numbers for premium bonds.
FPS PaymentA direct payment from one bank account to another using the Faster Payments Service (introduced in 2008). Usually clears same day.
FSCSFinancial Services Compensation Scheme. Protects savers, up to certain limits, from their bank or building society being unable to repay their savings.
Introductory Bonus RateA marketing trick used by some banks and building societies to offer a high initial savings rate, which is likely to fall when the bonus ceases.
National Savings & InvestmentsNS&I is a government backed business that offers a range of savings products, most famously premium bonds.
Notice PeriodThe period of time that some savings accounts require you to give notice when you want to withdraw money.
Premium BondsA government backed savings product where the return depends on winning tax-free prizes in a monthly draw.
R85A HMRC form that allows non-taxpayers to receive their savings interest without tax being deducted.
Regular Saver BonusA savings account that offers a very high rate of interest if you save a regular amount each month, typically for a year.
Restricted WithdrawalsSome savings accounts restrict the number of times you can withdraw money each year.
RPIRetail Price Index. A measure of UK inflation, includes housing costs such as mortgage payments.
Savings CertficatesA National Savings fixed term savings product, available with a fixed rate of interest or a return linked to inflation. Returns are tax-free.
Standing OrdersPayments that are made direct from your bank account to someone else on a regular basis.
SWIFT PaymentA direct payment from a bank account to an overseas acount using the Society for World-wide Interbank Financial Telecommunications service. Can take up to six days or more to clear.
TESSATax Exempt Special Savings Account, the forerunner to cash ISAs.
Tiered InterestSavings account interest rates that vary depending on your balance.
TOISATessa Only Individual Savings Account, a type of ISA available for money from maturing TESSAs, now extinct.
Top SlicingThe method by which the amount of tax owed, if any, is calculated when a GIB matures.
Uncleared Balance Includes money due to arrive in your bank account that has yet to clear. Money must normally clear before you can get your hands on it.