Challenger banks could earn you a better rate

"We are in the midst of a savings crisis in the UK," says Richard Theo, chief executive officer of online investment service Wealthify. "With interest rates remaining stagnant and inflation on the rise - forecast to hit 4 per cent this year - the BoE's continued inaction poses a very real threat to the UK's £700bn cash savings pot."

But we all need to have at the very least a small allocation to cash for emergencies, short-term needs or to ride out market volatility. And if you shop around, for example using comparison websites such as Moneyfacts.co.uk, MoneySavingExpert.com and MoneySuperMarket.com, you can find better rates.

How much cash you should hold depends on your personal circumstances. Martin Bamford, chartered financial planner and managing director of Informed Choice, says: "The rule of thumb is to hold cash worth between three and six months' expenditure, but that should be tailored to your individual situation, based on how cautious you are. Consider the likelihood of any potential emergency and how easy it would be for you to replenish that sum. Retired people, for example, should usually hold higher cash balances because they aren't earning income to replenish their cash pot."

It is also important to hold cash to avoid having to sell units of your investments when the market has fallen.

"From an investment perspective, cash usually features in portfolios to cover charges and a few years' worth of income withdrawals to avoid having to sell units when markets fall," explains Mr Bamford. "We used to say about three years was appropriate, but now we are recommending holding five years' worth of income withdrawals as cash, because we are nervous about market valuations."

Colin Low, chartered financial planner and managing director of Kingsfleet Wealth, says: "We would recommend having six months of normal expenditure in cash, but if anyone has a significant expenditure coming up in the next two to three years, we would say to hold that in cash too. We are nervous about the market at the moment and would suggest not relying on an investment portfolio for funds you might need to spend in the next two to three years, so you don't become a forced seller."

When it comes to choosing where to put your money, the first point of call for savings and investments has traditionally been an individual savings account (Isa). However the personal savings allowance means that sheltering your cash could be lower down the priority list than your higher interest-generating investments.

Since 6 April 2016 this has enabled basic-rate taxpayers to earn £1,000 of interest tax-free on investments including cash, bond funds and peer-to-peer loans. Higher-rate taxpayers can earn £500 a year interest on these tax-free, but there is no personal savings allowance for additional-rate (45 per cent) taxpayers who earn £150,000 a year or more.

For large chunks of cash it could be worth considering premium bonds issued by National Savings and Investments (NS&I). You can invest up to £50,000 in one bond and the prizes you win on them are free of UK income and capital gains tax, but winning is by no means guaranteed. Premium bonds also don't pay any interest. The prize rate (from May 2017) - the effective rate of interest on a bond - is 1.15 per cent - but that is relatively low if inflation keeps rising and not a guaranteed income.

You might well win nothing from premium bonds, making them a far less appealing investment, particularly if inflation eats into the value of your cash.

The challenger banks ramping up rates

Despite record-low interest rates, a group of new entrants to the retail banking market have succeeded in pushing up rates on savings and are topping best-buy tables.

Rachel Springall, finance expert at comparison website Moneyfacts.co.uk, says: "Savers have had little to hope for in recent years, but to everyone's amazement we have actually seen rate rises overtake cuts, with 67 rises against 53 cuts in January. This is mainly thanks to the challenger banks bringing some much-needed competition back into the market."

New names include Atom Bank, which offers services via a mobile app rather than high-street branches, and offers a rate of 2.05 per cent on a five-year fixed bond and 1.75 per cent on a three-year fixed account. Swedish Ikano Bank, meanwhile, has offered rates at similar levels to this since it entered the savings market in 2014.

The challenger banks are very different to traditional British high-street banks. Some don't have the costs associated with having physical branches or clunky IT systems, so are able to undercut some of the traditional banks when it comes to rates. And although critics argue that the good rates don't stick around long the challenger banks top the rates for one, three and five-year bonds in the UK.

Atom Bank offers the best deal for a one-year fixed-rate bond with a rate of 1.5 per cent rate.

Ikano Bank is also digital-only - savers can only open their accounts online - although customers can operate their accounts over the phone too. Charter Savings Bank customers can only open accounts online but the rate is high for a one-year fixed account at 1.38 per cent.

While the idea of banking with a new, small company you've never heard of might feel unnerving, with most of these your money is protected by the Financial Services Compensation Scheme (FSCS). Since January 2017 the FSCS guarantees deposits of up to £85,000 per person, per authorised bank or building society, up from £75,000. The limit for joint accounts moves to £170,000.

The FSCS also provides £1m protection for temporary high balances if your bank, building society or credit union fails. This covers sums of money up to six months from when the amount was first credited or from the moment a qualifying deposit became legally transferable. Temporary means that the deposit must have been credited to the account (or become legally transferable if that is later) no more than six months before the firm goes into default.

But Ikano Bank customers' deposits, for example, are protected under the Swedish Deposit Guarantee Scheme instead of the FSCS. This scheme too entitles you to compensation for the amount deposited up to £85,000 per person, per banking licence.

RCI Bank, meanwhile, is French so the first €100,000 (or sterling equivalent) per person, per banking licence, is protected by France Depositor Compensation Scheme.

Think before you fix

The best rates available are on savings accounts that require you to tie up your money for set periods and have increased year-on-year since January 2017, according to Moneyfacts. The best rate on a five-year fixed-rate bond was offered by Ikano Bank at 2.05 per cent, effective on 9 December 2016, but the best rate available as of 13 January 2017 is 2.10 per cent, offered by the Bank of London and the Middle East.

However, think carefully before locking up your money. In the UK an interest rate rise is likely in the next two years and when that happens the rate you are receiving is likely to seem less appealing.

"We often tell people not to trade off getting a better rate with tying up cash for too long," says Mr Bamford. "While rates might not rise in the next year or two, I would not suggest locking up your money for more than two or three years, because then your rate might be left behind by an interest rate rise."

Mr Low is even more wary: "I take the view that rates are going to rise faster than everyone is predicting, so I would not tie up money for any longer than a year, because we could be in a very different environment 12 months from now," he says.

Best rates on one-year fixed savers

Source: Moneyfacts, Moneysavingexpert and Moneysupermarket