By David Prosser
Saving money is straightforward, right? All you need to do is find the bank or building society account that pays the best rate of interest – and then pay into it as much as you can afford, both upfront and on an ongoing basis. Finding spare cash for savings may be challenging for many people, but the actual mechanics of saving appear at first sight to be much simpler.
If only it were that easy. In practice, people save for different reasons, often necessitating several different approaches. They struggle to stay disciplined and may need a bit of protection from themselves. And they worry about how to balance needs and goals which may be conflicting.
How, then, to approach such problems logically? One approach is to compartmentalise. That means breaking up your savings into individual pots of cash, with each one in place to meet a different requirement and allocated to the most appropriate savings products accordingly.
Start with the emergency fund
This savings strategy starts with your emergency fund – the pot of cash you put by to protect yourself against a significant financial setback. That might be the loss of your job, for example, or a sudden and unexpected expense; perhaps your car is on its last legs, or your roof needs a major repair.
The conventional wisdom is that you need an emergency fund equivalent to three to six months’ wages or living expenses. At the least, it should be enough to give you breathing space if a major problem suddenly occurs. And as well as deciding how much you need to put by, you’ll also need to think about where to hold this emergency cash.
Since you’ll need to be able to get your hands on this money at short notice – since no-one knows when disaster will strike – you can’t afford to tie it up. But there are plenty of easy access savings accounts that pay decent rates of interest while still allowing you to make withdrawals almost instantly, should you need to do so.
Alternatively, you might decide that an easy access account is just too tempting – that being able to make withdrawals so easily will make it more likely that you dip into your emergency cash even when there is no emergency. If so, one option is to hold the cash in an account that requires notice of withdrawals – a short period, but one that helps you to stay disciplined.
A 30-day notice account, for example, could provide you with still rapid access to your money, but with a brake on withdrawals.
Allocate for your ambitions
Next, think about the pots of cash you’re setting aside in order to meet specific savings targets – that could be anything from the cost of next year’s summer holiday to the financing of your children’s university years.
With these pots, you’re looking to maximise the amount of interest you earn, to give yourself the best chance of achieving your goal, but also to give your savings more structure over time.
Savings bonds can be a good option. These accounts pay a fixed rate of interest until they mature on specific dates in the future. You’re tying your money up until those dates – this can help you make sure that the pot remains intact until the time when you need it. Fixed-rate bonds can also help you secure additional interest – by protecting you from interest rate reductions in the future, for example. However, you may lose out if interest rates go up.
There’s plenty of choice. United Trust Bank offers bonds ranging from six-month accounts all the way up to five years, all currently paying from 3.98% to 4.04% Gross/ AER.
One issue to consider here is whether you’ll be making additional savings towards your goals. If so, fixed-rate bonds don’t normally accept top-up cash. A notice account is one alternative, still providing savings discipline, but accepting ongoing sums. Alternatively, some banks and building societies offer regular savings accounts, sometimes paying higher rates of interest if you make a deposit each month for a set term.
Focus on the long term
Many savers are simply trying to save as much as possible for the future, rather than for a defined purpose at a set time – perhaps you’re trying to build up extra cash for retirement, say. If that’s the case, you can still use notice and fixed-rate bonds; these will enable you to ringfence cash for the future while earning a decent rate of interest.
Easy access accounts are a possibility too, particularly if they offer a higher return; but you’ll need to be confident in your ability to leave the money alone in the short term. And make sure it’s held separately from your emergency fund.
Equally, long-term savings may be better off invested in other assets, such as shares and bonds, where there is the potential for superior long-term returns, albeit with the risk of ups and downs in the value of your money along the way. If you already have cash savings in place for emergencies and for your short- to medium-term ambitions and needs, it’s worth thinking about investing for the long term with your remaining cash. Take professional financial advice if you need it.
Don’t forget about tax
Finally, cash individual savings accounts (Isas) can also help you achieve your savings goals as part of a compartmentalisation strategy. Currently you can save up to £20,000 per year into Isa accounts across Cash, Stocks and Shares and Innovative Finance Isas. The exception is the Lifetime Isa account which has its own £4000 annual contribution limit and counts towards the £20,000 overall allowance. All interest earned in Isas is tax-free, which has the potential to save you considerable sums over the long term. Cash Isas also come in different forms, including easy access accounts and fixed-rate bonds.
Inside or outside an ISA, the goal here is break up your savings to match up separate pots with your separate motivations. It’s challenging to manage a single pot of money when you have different goals in mind – you’ll have to make unwanted trade-offs and compromises, and you’ll find it difficult to keep track of your progress.
Much better to compartmentalise – that way, every penny of your savings can be put to work in the best way possible given your intended use of the money.
*AER stands for Annual Equivalent Rate and illustrates what the interest rate would be if interest was paid and compounded once each year. Gross is the interest rate without the deduction of income tax. Interest is paid gross into your account.
Although this article may contain helpful information and tips, these are not personal advice. You may wish to seek advice from a financial advisor if you are unsure what’s best for your own personal circumstances.