Open a Cash ISA regardless of interest rate

by Adam on April 5, 2010

It’s ISA season in the UK. Firstly Magical Penny told you to avoid the frenzy, Secondly  we detailed why you should open a Cash ISA. Today we’re hammering the message home with why you should stick with ISAs despite the low interest rates available.

ISAs stop your money being rained on by tax

ISAs are great savings accounts because all the interest is tax-free –acting as an umbrella from the rain of tax on your money. You don’t have to give any earnings from interest to the government (unlike any other account where your bank automatically deducts the government’s cut before you see it). But what should you do when the interest rates on ISAs are much lower than can be found in other types of savings accounts like now?

The controversy

Banks advertise when they have a market-leading interest rate on one of their accounts. Why? Because a market-leading rate can bring in a flood of new money, which they then can invest in the hope of an additional return for themselves. As ISAs have grown in popularity they have become highly profitable for banks who offer low rates on ISAs as they know there will still be demand for ISA accounts due to their favourable tax status. They don’t need to give their ISAs a competitive interest rate so they can keep more money in their own pockets. Although this practice is not ideal I think opposing ISAs for their lower interest rates misses the point: Is it still worth having an ISA? Yes. And here’s 3 reasons why:

1. All good interest rates are temporary

When you look for different places for your money you may well come across a number of seemingly ‘killer-deals’: perhaps a regular saver account that promises 5% or more, or a term deposit offering double the interest rate of a normal savings account. Whilst these can be appealing in the short-term, such accounts never remain competitive for more than a few months. Most financial providers offer these market-leading rates to attract new business and then notch the interest rate down in the hope that inertia on the part of the customer will keep them there, in a sub-optimal account (As Rob mentioned in the comments). Rather than rate-chase it makes sense to get your money into the ISA system and then search for good deals rather than keep it in a taxed account which most likely will not be a ‘killer-deal’ for long.

2. Terms and Conditions Apply

Another thing to look out for on financial accounts offering great interest rates is the number of terms and conditions attached. Financial providers add limitations and conditions to protect themselves from making a loss on you as a customer. Examples could be forcing you to tie your money for a certain amount of time, limiting the number of withdrawals, or requiring you to increase your balance each and every month. Sometimes these terms and conditions are worth it and you can get some amazing returns but make sure you are in a strong enough financial position to keep your end of the bargain.

In 2008 I managed to get 10% on my money, risk-free, using a regular saver account. But if I hadn’t had a strong financial cushion this could have gone very wrong as for months at a time I had several thousand pounds ‘locked up’-unavailable if I had needed it. It was a fun and profitable experiment but on reflection it’s not something I would recommend unless you have a huge ’emergency fund’ and if you have so much cash about then it’s likely another asset class would be better anyway (more on this in later posts)

In most cases, the increase in interest rate isn’t worth the trouble: for example you may have a promotional current account that offers an amazing credit interest but as it’s a current account you’ll be tempted to spend it, or perhaps a fixed deposit might promise a great return but it won’t be there if you need it. You would better off getting your money into an instant access ISA: think  about why are you saving in cash in the first place: for flexibility, safety and security. You don’t want conditions tying you down for the sake of a couple of percentage points.

3. Tax Benefits are forever…

…Well, maybe not if the government changes the rules but for now the tax benefits on ISAs are unmatched. Not only do you get to shield your money from tax this year, but growth is shielded in all subsequent years. It might not immediately seem intuitive to be paying into ISAs that offer lower interest rates than other accounts, but over the course of a few years getting your money under the ISA umbrella is the best thing to do. For medium term goals that take a number of years of saving, like if you’re saving for a house, then it makes sense to ‘future proof’ your savings from tax.

That’s not all

Once your pennies are under the umbrella of an ISA, protected from the rain of tax, you continue to have options. That’s right, the fun continues! You can transfer to better performing accounts within the ISA framework and even transfer your ISA funds into a Stocks and Shares ISA –the bigger and better cousin of the humble cash ISA…but that’s a discussion for another day!

Happy New Tax Year everyone.

Further reading

  • If you can’t get enough reading about ISAs perhaps you’ll enjoy a new UK finance blog discovery of mine @ShrewdCookie

Magical Penny was featured in Carnival of Personal Finance #251. Thanks MBH. So many quality articles worth reading.

If you’re new to Magical Penny be sure to read all the articles on Saving.

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