Updated on 27 May 2015.
Premium Bonds offer savers the chance to deposit between £100 and £40,000 (rising to £50,000 on the 1st June 2015) entirely risk-free. The secure savings option is run by NS&I (National Savings and Investments) and backed by HM Treasury, so you will never have to fear losing you deposit.
However, the prize draw format means returns are not guaranteed and for the majority of Premium Bond holders, returns are on average much lower than could be expected of a normal savings account.
Rather than interest, Premium Bonds are incentivised with cash prizes, with an estimated 1,975,032 handed out every month to the lucky winners across the country.
What makes premium bonds different to standard savings accounts is that instead of earning regular interest on your invested money, each £1 bond is attributed a unique number, every one of these numbers is entered into a monthly prize draw, with prizes of between £25 and £1million handed out to the winners.
The chance of winning a £1million jackpot has made premium bonds hugely popular with UK savers, ever since they were first introduced in 1956. But the likely-hood of winning big or indeed winning anything at all causes some to call into question the value of Premium Bonds as a viable investment option, especially for those interested in earning a substantial, consistent return on their deposit.
Every month ERNIE (electronic random number generator) churns out winning numbers from all of the bonds currently held across the entirety of the UK population.
Currently standing at around £60-million pounds, the prize draw is split into higher value, medium value and lower value categories with prize volumes increasing as the prize value decreases. Approximately 7% of the fund is offered as a higher category prize (between £1 million and £5,000), 5% at Medium value (£1,000 to £500) and 88% at Lower Value (£100 to £25). This is updated every three months and can be found on the prize checker page of the NS&I website.
The prize fund for each month's draw is determined by an interest rate applied to the total bonds held. Until July 2013 the prize fund was set using an interest rate of 1.5% however this has since been reduced to just 1.35%, meaning your actual odds of winning a prize per £1 bond are now around 26,000 to 1.
Clearly, as you increase the money that you have invested in Premium bonds, the number of 26,000 to 1 'shots' you have to win increase. In simpler terms, the more you have invested the more you are likely to get in return in the form of prizes.
If you open a premium bonds account you are able to invest between £100 and £40,000.
You can buy bonds online from NS&I over the phone, at the Post Office, or with a regular monthly payment by standing order. Anyone over the age of 16 can buy them, or they can be purchased by parents or grandparents for those aged 16 or under which make them a viable option for those looking for a tax free investment option for their children after junior ISA limits are used up.
The bonds each come with a unique number and are put into a prize draw a month after you've bought them. They will be re-entered in each subsequent draw until you decide to cash them in.
In times of banking instability, you may be comforted to know that investing your money in Premium Bonds guarantees that your money, up to the maximum of £40,000, is completely safe. This is because NS&I is backed by HM Treasury. Also, your capital itself is not gambled in the prize draw - only the interest that you might have earned on that capital.
Another thing worth noting is that there is no minimum length of time that you must hold the bonds. You can cash them in any time you like from the time you invest, although new bonds can't be cashed in for a month after they are first purchased. Also, it will take up to 8 days to withdraw the money after you have decided to cash in.
If you do win a draw, any prize money (from £25 to £1million) will benefit from tax-free status, making Premium Bonds a worthwhile consideration if you pay the higher rate of income tax and have already used your ISA limit for the financial year. You may also opt to re-enter your winnings into the draw in the hope of winning even more, an idea which is supposed to imitate the compound interest you would get on a standard savings account (the interest earned on top of interest over a year).
Unfortunately, the many catches of investing in a premium bond arguably outweigh the benefits. Firstly, it's worth considering exactly how likely you are to win in the monthly prize draws and whether your money would generate better returns when invested within a conventional savings account.
Of an average 50 billion bonds entered in the prize draw each month, the prize ratio works as follows:
This means that your chances of winning the top £1million prize are about 50 billion to 1; odds that make a jackpot win at the National Lottery seem a sure bet in comparison (around 14 million to 1).
Another thing that should be taken into account is that although your invested capital is safe in a premium bond, inflation means the value of that money will go down over time - and with no interest earned to offset that loss of value you'll effectively end up with less than you started with.
The NS&I refer to any payouts as 'wins', the lure of which can be very attractive to those wanting to earn some money back on what they invest. However, you are likely to win less, over the course of a year than the interest you would have earned on a standard savings account. Currently, investing your money in a top savings account or tax-free ISA would likely be a better option.
These will enable you to earn money on what you invest and will pay you a better return than the average you will get back from premium bond wins. You could even think of the interest paid on your savings as a 'win' in itself - and one that is guaranteed to be paid out to you on a regular basis.
In general, premium bonds aren't really worth considering in terms of a realistic return on your money. Although there is a chance that you could win big, the probability of hitting the jackpot is negligible at best. Those looking for reliable returns should turn to ISAs or savings accounts to maximise the worth of hard earned savings. Read our guides to find the very best savings accounts or making the most of your cash ISA.
If you are a higher-rate taxpayer and have already used up your tax-free ISA allowance in its entirety, or the chance of winning a life changing sum, no matter how slim, is too tempting to pass up, then perhaps Premium bonds could suit you. But for the majority of savers who want or need to earn regular interest, a top-paying savings account is likely to prove itself to be a better option.
In this way, premium bonds should be seen not as a viable savings account or investment, but as a way to forego earning interest in favour of chancing that interest on the possibility of winning money.
Written by Sally at money.co.uk
If you've inherited some money, received an unexpected windfall or saved up a tidy sum, knowing what to do with the money can be tricky. Here's what to do if you have a significant amount to invest.
Has your savings rate got you looking for alternative ways to use your hard earned money? Whether it's for long term growth or to generate income, investing in shares can be a profitable way to use your savings!
Have you had enough of staring at poor weather and the low savings rates available in the UK, buying a property abroad could not only improve your view but your wallet too! We look at the pros and cons of investing in property overseas.
You don't have to be a billionaire oil magnate to invest in a football club; putting your money into something you care about can feel more rewarding than shares in some faceless plc. But if you put your head before your heart, is it a smart investment?
I have a significant amount of cash: What's the best place for my money?
What is your new tax-free personal savings allowance?
4 tax efficient ways to save for your children
How to make your savings work harder
6 tips to get the best rate on your savings
How to start investing in shares
Investing in property abroad: pros & cons
How to invest in your football club
7 questions you must ask before you invest
What's the difference between income and accumulation funds?
Get expert tips that will help you spend and save smarter, even if you're short on time.