MoneyMagpie

Sep 07

Beat inflation with index-linked bonds

Updated 15/1/13

Now National Savings & Investments (NS&I) have removed their very popular Index-linked bonds, it’s getting harder to find a savings account that will beat inflation. It’s still possible though – read on to find out how. 

 

What are index-linked bonds?

money_2196794bThey are savings bonds which, instead of having a rate of interest set by the bank, track a certain ‘index’. Often this can be a  particular stock market index, but in this case it is the Retail Prices Index (RPI)

What’s the RPI? The Retail Prices Index or the RPI is a measure of inflation (not the official one, but still used by the Government to make certain calculations). It’s also a popular measure of the cost of living and the most recent figures, published in April 2012, had it at 3.5%. So really these are inflation-linked bonds.

OK, so what does that mean for your money? The best you can hope to get with a fixed rate bond is about 2.75% after tax – not even close to beating inflation. A bond that tracks RPI will give you roughly 5% (and some of them include a bonus on top of that too). Plus some are even offered as an ISA so you won’t have to pay tax on your earnings.

So what’s the catch? There’s only one real drawback with these bonds – you have to tie up your money for a few years. This means that not only can you not get your hands on your money in that time, but also, if inflation drops right down and interest rates go up, you will find yourself making less money than you hoped.

 

Should you choose one over a standard savings bond?

What these accounts are essentially doing is protecting your money from being eroded by inflation – so when you save, your savings are not losing value in real terms (which is unfortunately what is happening with most other standard savings accounts).

The best interest rate for a five-year fixed rate bond (with a minimum investment of less than £500) right now is 4.65%, and that’s before tax. Meanwhile, the best five-year fixed rate cash ISA at the moment also offers 4.5%.

Initially the index-linked bonds (including the fixed bonus) would be beating these rates, though of course there’s a chance that inflation will fall  – meaning your interest in an index-linked bond might drop below 5%. It really depends how much you believe that inflation will go high and stay high. No one really knows but, in the next year at least, it is likely that inflation will stay high while interest rates, though they may go up a little, will stay low.

Even if, over the five-year period, it drops to the Government’s target of 2% – the RPI is likely to be at about 2.75%, so with that plus the account bonus, you’ll still be making about 4% (before tax if it isn’t an ISA).

While there is obviously an element of risk involved,  remember that even if inflation falls into negative numbers (i.e. deflation), you’ll still be getting the fixed bonus regardless.

 

What else can you do to protect your money from inflation?

Protection of money. Isolated 3D image on white backgroundAnother way to beat high street savings rates is to get into social lending. Essentially this is when savers lend to borrowers direct – cutting out the banks means that savers get higher interest rates, and borrowers get more competitive loans.

There are a few websites which operate this peer-to-peer lending and at Moneymagpie we particularly like Zopa.  In fact, Jasmine herself is a Zopa lender. They say that lending through them will make you on average 5.4% interest –  above the rate of inflation. Find out more about social lending with Zopa here.

If you are prepared to tie up your money for the longer term then investing in a stocks and shares ISA is a good, tax-free option. Obviously this is the stock market so there is an element of risk involved, but you can stick to the less risky options if you are new to investing. They are much less scary than you think so find out more about simple stocks and shares ISAs and why we think they’re a great idea here.

Don’t forget that if you have debts to pay, you could be better off paying the money back than putting it in a savings account. Sounds crazy, but here’s why.

Consider mortgage repayments versus a savings account. An average mortgage rate at the moment is between 3.5 and 4%, so essentially every £100 of your mortgage is costing you at least an extra £3.50 a year. In comparison, the average rate for an easy access savings account is only about 1%, so £100 in that account will only be earning you (after tax) about 80p.  Which means of course that in the long run, you’ll be saving money by paying off those debts.

 

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