The case for (and against) owning Premium Bonds

From March, Premium Bonds will start paying out less than they currently do, as the prize fund rate is cut from 4.65 per cent to 4.40 per cent. At times during the past year they represented the highest-paying easy-access account available on the market, but this is no longer the case. 

While a rate reduction of 0.25 percentage points does not move the dial enormously, the change means it is worth revisiting your Premium Bond holdings and considering whether they are still the best place to park your cash.

For a lot of people, Premium Bonds are not necessarily the best option. As Holly Mackay​, founder and chief executive of Boring Money, puts it, while not liking Premium Bonds is “heresy to some… for the vast majority of us, there are better options, offering either the certainty of cash or the better longer-term potential of the stock markets”. But they can make sense for higher-rate taxpayers who use up their individual savings account (Isa) allowance every year.

The maths

Keep in mind that the prize fund rate is not what you will receive, but only the 'effective' interest rate. Every month you have a one-in-21,000 chance to win a prize for every £1 you put in, with prizes ranging from £25 to £1mn. This means that the more money you invest, the higher your chances of winning, although achieving the advertised rate of return is not guaranteed even if you invest the maximum £50,000, and you could still theoretically receive nothing however much you invest. 

MoneySavingExpert’s bond calculator estimates that somebody who invested £10,000 in Premium Bonds and had average luck would win £350 over a year, a 3.5 per cent rate of return. The provider warns that its complex calculator is now no longer perfectly accurate due to the various changes to the prize pot announced over the past year. Nonetheless, it shows that your returns could easily be below the prize fund rate.

Even using the prize fund rate for comparison, Premium Bonds pay less than the best easy-access savings accounts you can find on the market. As of 12 January, the highest rate on offer was 5.22 per cent, from Metro Bank. Depending on how savings rates move over the next few months, this gap could expand once the prize fund rate is cut in March. When that shift happens, the odds of winning a prize will remain the same, but the number of prizes worth between £50 and £100,000 will be reduced in favour of those worth £25.

Nonetheless, the move is part of a wider trend. Fixed-term savings rates have come down in the past few weeks as financial markets become increasingly optimistic about the likelihood of interest rate cuts by the Bank of England later this year. Laura Suter, director of personal finance at AJ Bell, says the cut to the Premium Bond rate “is the biggest sign yet that the rates bonanza enjoyed by savers is coming to an end”.

While easy-access rates have held up better than their fixed-rate counterparts so far, they also appear to have peaked towards the end of last year, as the chart below suggests. The average easy-access savings account rate reached 3.19 per cent at the beginning of November 2023 but had dropped slightly to 3.15 per cent by January this year.

Further cuts to Premium Bonds’ prize fund rate are expected. National Savings & Investments (NS&I) has already hit its fundraising target for the tax year, partially thanks to its one-year fixed-rate bonds. The organisation hurriedly pulled them from the market after almost a quarter of a million people invested in them in just five weeks. For the moment, NS&I no longer needs to attract savers with table-topping rates.

“NS&I has opted to trim the rate rather than slash it. It will likely continue to bring rates down from here in small increments, as it gauges the popularity of Premium Bonds when savings rates are falling,” Suter says. 

Who should hold Premium Bonds

As NS&I itself makes clear on its website, savers who are looking for a regular income, prefer guaranteed returns or are hoping to beat inflation should stay clear of Premium Bonds. But what makes them advantageous for many is that the wins are tax-free.

Higher interest rates mean many savers are now at risk of breaching the personal savings allowance, which is set at £1,000 annually for basic-rate taxpayers, £500 for higher-rate taxpayers and zero for additional-rate taxpayers. Assuming a 5 per cent rate of return on the cash, a basic-rate taxpayer hits the allowance with £20,000 saved and a higher-rate taxpayer with £10,000. After that, marginal tax rates apply, which means that if you pay the basic rate, your 5 per cent savings account actually pays 4 per cent; falling further to 3 per cent for higher-rate taxpayers and 2.75 per cent for those paying the additional rate.

The principal alternative for those looking to save their cash is a cash individual savings account (Isa). But investors should prioritise using their £20,000 annual Isa allowance on their stocks and shares Isa, in order to shelter future gains and dividends from capital gains tax and dividend tax. Cash Isas also tend to offer slightly lower rates than their non-Isa counterparts – Metro Bank’s easy-access cash Isa currently pays 5.11 per cent, for example.

Taking all this into account, Premium Bonds become an attractive alternative for higher and additional-rate taxpayers who exhaust both their Isa and personal savings allowance. There is still an element of luck involved, but you need less of it once you account for the tax savings you are making.

Finally, Premium Bonds are government-backed, which makes them extra safe. Bank deposits are protected up to £85,000 by the Financial Services Compensation Scheme, meaning amounts above this level are not guaranteed in the event a provider goes bust. NS&I, as a government-backed service, does not carry this risk. “It’s a marginal difference, but some people will feel much safer with their savings being with the government,” Suter notes.