Something strange is happening in the world of savings. Normally, the longer you lock away your money in a savings account, the higher the interest rate you receive. Providers reward you for entrusting them with your money for long periods.
But in recent weeks, a growing number of providers have been reversing this trend. They are offering the same or lower rates on five-year fixed rate accounts than on one or two-year fixes.
Laura Suter, head of personal finance at wealth platform AJ Bell, says: ‘For the first time since 2016, average fixed-term accounts with a duration of two years or more are paying less than the average for those where the term is fixed for less than a year.’
The average interest rate on fixed-terms bonds of one year or less was 3.37 per cent in February, the latest Bank of England data shows. For fixed-term bonds of over two years, the average interest rate was 2.45 per cent.
Why is this happening?
Savings providers price their deals according to what they expect the Bank of England’s base rate to be in the future.
Under lock and key: Savings providers price their deals according to what they expect the Bank of England’s base rate to be in the future
They don’t want, for example, to be paying savers five per cent interest a year in four years’ time if interest rates have dropped to two per cent.
Financial markets are predicting that the base rate is nearing its peak and may even fall in the coming months. That is because the rate of inflation is expected to drop sharply later this year, which will mean the Bank of England will no longer have to raise the base rate to tame it.
Myron Jobson, senior personal finance analyst at wealth platform Interactive Investor, says: ‘It might appear counterintuitive for savings providers to offer a lower rate of interest on longer term fixed deals, but it underlines the belief that the interest rate hike cycle is close to an end, with inflation forecast to cool significantly this year.
‘Having to pay a higher rate of interest on savings long after interest rates have fallen could eat into savings providers’ profit margins.’
How long should you fix?
Ask yourself when you will next need to access your savings. You can’t usually access them for the duration of a fix so don’t lock your money away for longer than is practical.
If you will not need to touch your savings for several years, you may decide it is worth accepting a slightly lower rate now for a longer fixed-rate account. That way, if interest rates do fall sharply, you’ll still be receiving a good rate.
However, if you disagree with current forecasts and think rates may continue to rise, you may be better off fixing for a shorter term and then taking out a new fixed-rate deal when that one expires. For savers uncertain about what to do, Laura Suter suggests a middle ground. ‘You could save half in a longer-term fix, put the rest in a shorter-term fix and take your chances with what rates will be when that fix comes to an end,’ she says.
Which are the best rates?
There is very little to choose between two, three and five-year fixes at the moment.
For example, SmartSave is offering 4.51 per cent on a one-year fix; Al Rayan is offering 4.68 per cent on a three-year fix, and United Trust Bank is offering 4.65 per cent over five years. Atom Bank is offering 4.45 per cent on its two, three and five-year fixed rate accounts.
What about tax?
When taking out a multi-year fixed rate account, pay attention to how interest is paid. Some pay interest annually, others pay it all at the end of the fixed rate term. If you opt for the latter, you are more likely to risk being hit with a tax bill. You have to pay tax on interest earned over your Personal Savings Allowance (PSA). Basic-rate taxpayers have a PSA of £1,000; higher-rate taxpayers have £500 and additional-rate taxpayers have none.
If you receive the interest on a multi-year fix all at once, there is a higher risk that you will exceed your PSA than if you receive it spread out in yearly instalments.
If you save in an Individual Savings Account (Isa) there is no tax to pay on any interest earned.
Any other alternatives?
If you know that you will not need to touch your savings for at least five years, ask yourself if you should be investing instead.
Over the long term, investing prudently tends to yield a better return than interest on savings. However, you should only invest money that you will not need to spend for at least five to ten years.
Sarah Coles, head of personal finance at wealth platform Hargreaves Lansdown, says: ‘If you are tying the money up for five to ten years or more, then it’s worth at least considering investing. You will be taking investment risk, so this may rise and fall in value over the short term.
‘However, the idea is that if you have a balanced portfolio, over the long term, you should have time to ride out any fluctuations and take advantage of more potential growth.’
