How to earn 5%+ on your savings

If you're after the best possible return on your savings, fixed rate bonds are the place to look.

Hardly a day goes by without the launch of yet another fixed rate bond. It looks like competition is fierce among the banks and building societies, but does this mean more generous returns for savers?

Well, there's no doubt some of the rates are improving, especially for longer-term bonds. According to lovemoney.com partner Moneyfacts, the average return from a five-year bond was 3.33% at the beginning of the year, but it has now climbed up to a more impressive 4.61%.

What's more, the top rates can be as much as 2% higher than those offered by easy access savings accounts.

Are fixed rate bonds right for me?

You'll normally need a lump sum of around £500 to £1,000 to open most fixed rate bonds. If you don't have that much or want to save small amounts regularly, you should opt for either a regular or an instant access savings account instead.

If you do have a lump sum, a fixed rate bond is a great choice for earning a guaranteed return on your cash. But you'll need to sacrifice access because withdrawals aren't usually allowed while the rate is fixed. So, don't take a bond out unless you're absolutely sure you won't need your money back before the fixed-rate term is up.

You'll also need to think carefully about how long you want to tie your savings up. Bonds are generally available over one to five years. If you don't want to commit yourself to a long-term savings bond, choose one which lasts a year or two at most.

But, most importantly, remember there's a risk your fixed rate won't stay competitive for the whole term. If the returns from variable rate accounts improve dramatically, you could find your bond is left behind. Of course, the longer you fix your rate, the greater that risk is.

So whether you want to open a bond for one year, or several, here are my top picks:

Short-term bonds (1 - 2 years)

You'll be pleased to know you can now earn well over 3% with a short-term bond.

Those of you with a £1,000 or more to put away for a year won't go far wrong with Chelsea Building Society. Here you can earn a decent rate of 3.80% on the Summer Bond 2009.

I think this bond measures up pretty well because it offers an extra 0.50% on the current market-leading easy access account - Citibank Flexible Issue 6 -  which pays 3.30%. I would expect this rate to remain competitive compared with the wider savings market over the next 12 months.

If you would prefer to stash your savings away for a little longer, you can earn a market-leading rate of 4.35% with the Internet 2 Year Fixed Rate Bond from The AA on savings of £500 or more.

Alternatively, if you want instant access and a fixed rate, the ING Direct instant access savings account offers a fixed rate of 3.2% AER for the next year, yet also allows penalty-free instant withdrawals.

Medium-term bonds (3 - 4 years)

The rates get even better the longer you lock your cash away. If you choose a medium-term bond of say, three or four years, you can expect to earn rates easily in excess of 4%.

The best buy three-year option is Barnsley Building Society Online Bond which pays a great rate of 4.70%. Although the bond is marketed as a three-year account is doesn't actually mature until 28 February 2013. So technically it runs for almost three-and-half years.

If you can afford to put your money away for slightly longer, Barnsley is also offering a four-year Online Bond which pays 5%. And both bonds are fantastic for smaller savers, with a minimum opening deposit of just £100.

Just be aware that, by giving up access to your money for three to four years, you are only gaining an extra 1.40% or 1.70% AER (remember, the best instant access account pays 3.3% AER). So again, you'll need to decide whether you think this extra return justifies locking your money away for such a long period. Bear in mind that, if interest rates go up, variable rate accounts could offer much higher rates during the next few years - yet the rates on the Barnsley Online Bonds will stay exactly the same.

Longer-term bonds (5 years)

If you like the idea of finding a home for your savings now, and not having to think about them again for a good few years, then a five-year bond could be right up your street. Today's best buy breaks through the 5% barrier with a great rate of 5.30% from Yorkshire Building Society's Fixed Rate E-Bond. Once again you only need £100 to open the bond.

Here's what I would do

There's no doubt that the rate on the Yorkshire bond is generous when you consider that the base rate is still just 0.50%. But for me, it's a dilemma. I'm just not sure a return of 5.30% is going to keep ahead of the competition over the next five years.

Earlier in the year, this dilemma was easier to resolve since the gap between the rates paid on short and long-term bonds was much narrower than it is now. As there wasn't much difference between them, it made more sense to go for a short-term bond, and have greater access to your money in the future.

But now the banks and building societies have stepped up the rates on long-term bonds, to make them more attractive. And so the question is a little more tricky to answer.

In the end, I think that personally, I would still pick a short-term bond that pays around 4%. I believe this will probably generate a better return over the next year or two than the top easy access accounts.

But I'm not quite so confident the same can be said of the higher rates payable over the long term. Once the base rate starts to climb again, which is it is likely to do at some point over the next five years, the return from variable rates accounts will improve accordingly, and I can see the rates on longer bonds could start to fall behind.

Of course, I could be wrong. At the end of the day if earning an annual return of more than 5% on your savings for the next five years seems like a good deal to you, then why not go for it? Believe me, there are plenty of worse financial decisions you could make!

Compare savings accounts at lovemoney.com.

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