Why you should ignore Cash ISAs

Cash ISAs can be a great tax break, but over the past year their interest rates, in common with other types of savings accounts, have plummeted. So if you’re looking for better returns, it could be time to look elsewhere.

What’s happened to Cash ISAs?

The main reason behind the dramatic fall in Cash ISA interest rates is the Bank of England’s Funding For Lending scheme. This has offered banks and building societies the chance to borrow at lower than normal interest rates in a bid to increase lending to businesses and to us.

Ordinarily, the banks and building societies rely on our savings deposits to give them money to lend. But with cheap cash available from the central bank, there’s very little incentive for them to offer us decent rates in return for our savings. So rates have been cut.

Alternative #1 – stocks and shares ISAs

If you still want to use your tax-free ISA allowance, you could look at a stocks and shares ISA. You can actually put more away in a stocks and shares ISA – up to £11,280 in this tax year.

However, it’s worth saying at the outset that these should be considered as a longer-term investment; in other words if you won’t need access to your money for a while.

And they’re not for everyone – it all depends on your attitude to risk. There are no guarantees you’ll get a good return. Having said that, historically the longer you put your money away, the lower the risk you’re taking and the better the returns.

Think of a stocks and shares ISA as a protective wrapper, into which you can place different investments and shield them from tax.

Index trackers

The cheapest and simplest option for this type of ISA is an index tracker. These track the performance of a particular stock market index. So if London’s FTSE 100 index rises by 10%, a FTSE 100 tracker fund will rise by roughly 10% too.

That return will then be reduced a little by an annual charge, but with index trackers, the charges are low. That’s because the shares are picked by a computer, not a highly paid fund manager in the City.

The Fidelity Moneybuilder UK Index tracker is one of the best UK index trackers. It tracks the FTSE All-share index, which comprises around 630 companies. The charges are low at 0.3% a year, and you can invest in the fund through a Fidelity Stocks & Shares ISA. Fidelity is also currently offering 50% off its annual management charges for 12 months.

Other options include the SWIP FTSE All Share Index tracker. This has a Total Expense Ratio (TER), the total amount of charges, of 0.11%, although it’s only available via investment specialist Hargreaves Lansdown, who charge a £2 a month platform fee as well. Or there’s the HSBC FTSE All Share, which has a TER of 0.27%.

Another thing you should bear in mind is the tracking error. This is how closely the tracker tracks the index it’s following. The greater the deviation, the less reliable the fund.

You can also put individual shares, unit trusts, OEICs and investment trusts into a stocks and shares ISA. But bear in mind that management and trading fees can eat into your returns.

[Related link: Compare stocks and shares ISAs]

Alternative #2: peer-to-peer savings

Peer-to-peer websites allow you to lend money to both other people and businesses and potentially get a greater run than via normal savings accounts.

However, your money isn’t free from Income Tax as it is with an ISA and it also isn’t protected by the Financial Services Compensation Scheme, which guarantees the first £85,000 of savings you hold with participating institutions.

On the flipside, Funding Circle says it is paying an interest rate of up to 8.9%, while RateSetter’s five-year income account offers a fixed rate of 5.8%. Even after tax, they thrash the best Cash ISAs.

[Related link: Compare peer-to-peer savings]

Alternative #3: pay off some of your mortgage

If you can pay off some of your mortgage without incurring an early repayment penalty, this might be a good option, particularly if your interest rate is fairly high (say over 3%).

Although you’ll be missing out on the effect of compound interest over time (interest earned on interest) by not saving the money, you’ll be mortgage free quicker. Then you’ll have more money to save.

Losing your ISA allowance

Bear in mind that if you decide not to use your ISA allowance this year, you’ve lost it for good. So you won’t be able to take advantage of being able to transfer your old ISAs into a better-paying one when rates do improve. And if you don't like risk, you might be better off sticking off with a Cash ISA.

[Related link: Compare Cash ISAs]