Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

I’m seriously considering sticking the bulk of my cash savings into Premium Bonds.

I’ve watched the interest paid on my cash savings account fall by more than half in the past year and, after a bit of Google research, am now willing to forego the little interest it pays for the chance of cash prizes from Premium Bonds.

It’s the first time I’ve really considered them as anything more than a novelty. Issued by National Savings & Investments (NS&I), the state-backed savings provider, one Premium Bond can be bought for £1. Bonds are then entered into a monthly prize draw. Prizes ranges from £25 to £1million. Their reputation is more of something a godparent might gift to a child than part of a serious financial plan - but I’m beginning to see them differently.

There’re a few competing factors in my decision. Firstly, this is money I have earmarked specifically for cash savings which I don’t want to risk losing - so I don’t see investments, where there is the chance my money could lose value in cash terms - as an alternative home for it. Investments are still the focus for my long-term saving and the regular contributions I make will continue to go into investments, mostly the stock market. The cash I have is separate from that and is not currently being added to.

Holding some cash - between three and six months’ worth of income which you only use in an emergency - is an important part of any financial plan. Having that level of cash means I can worry less about needing funds in a hurry and, in turn, it allows me to be more relaxed about the performance of the investments I have because I’m less likely to have to raid those at the wrong time. This is the money I may switch to Premium Bonds.

Secondly, I need to consider inflation. One of the risks of Premium Bonds is that the value of your holdings is eroded by inflation over time. If I buy one premium bond for £1, I can get that money back when I like but I’ll only get £1 back. If I hold my Premium Bond for many years, the buying power of £1 is likely to have fallen due to inflation.

Right now, the consensus opinion is that inflation is about to accelerate, so the value of Premium Bonds will be eroded more quickly. That is not ideal, but it needs to be compared to the reality of saving into a cash account. Inflation may rise, and the Bank of England may raise its Bank Rate in response, but that’s not the same as saying cash accounts will pay more to savers as well. Commercial banks get to set their own rates and they may not pass on all or any of a rise in the Bank Rate. My current savings account - which allows access to my money when I want but limits withdrawals to two a year - pays 0.51%, so still less than the current 0.7% rate of inflation - I’m losing money to inflation already.

And if savings accounts do suddenly begin to offer much better rates, I could always switch out of Premium Bonds to take advantage of them.

Finally, I need to understand the likely potential returns from Premium Bonds versus a savings account. The interest you get on savings can be lowered, depending on the account you hold, but is otherwise guaranteed. The potential return from Premium Bonds depends solely on you winning prizes. The NS&I website explains exactly the prizes on offer but it also publishes ‘annual prize fund rate’ - a figure designed to show the average return of someone who holds Premium Bonds. The annual prize fund figure is currently 1%.

That figure should be treated with caution. It is certainly not equivalent to an interest rate and represents only the mean average return from prizes, so included in that average are the people winning £1million prizes which skews the figure.

The maths governing the Premium Bonds process is mind-bending and it would take a statistician to understand completely. (Hat tip to Moneysavingexpert.com which has done sterling work breaking it down.) Some things about it are fairly simple, however, including the fact that the more bonds you own, the greater chance you’ll have of winning enough in prizes to earn that 1% annual prize fund rate from your bonds.

With the amounts I have to potentially use to buy Premium Bonds, I’m happy that I’d have a decent chance of making up in prizes the amount I will have lost in interest. Added to that, I’ll have a (very, very slim) chance of winning a large prize. The downside is that I may not win anything and will have lost any return from interest in a savings account.

That’s a bargain I’m willing to make. As explained, this money is there for an emergency and getting a return is not the primary reason for holding it. I need it to be safe and accessible, which Premium Bonds provide as much as a savings account does, and I’m happy to exchange a paltry amount of interest for the day-dream of a big Premium Bonds win.

Important information

Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to a Fidelity adviser or an authorised financial adviser of your choice.

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