Earlier this week, I read that two people in London had just won £1m through Premium Bonds. Unfamiliar with these bonds, this piqued my interest and I did a little research into how they actually work. Here’s what I discovered.
What are Premium Bonds?
Premium Bonds are a financial product issued by National Savings and Investment (NS&I). Unlike regular bonds, where you earn interest in the form of coupon payments, Premium Bonds do not pay any regular income. Instead, bondholders are entered into a monthly prize draw (once bonds have been held for a month) where they can win between £25 and £1m tax-free.
You can invest as little as £100 (or £50 if you set up a regular contribution) and the maximum you can invest is £50,000. Any money invested with NS&I is secure because it’s backed by HM Treasury, and you can also redeem your bonds with no penalty.
Are Premium Bonds worth buying?
Are they a good long-term investment? In my view, no. While some people obviously hit the jackpot and win big, most people don’t. According to the NS&I website, the odds of winning for each £1 bond number is 24,500 to 1. And the odds of winning the larger prizes are no doubt much worse than that. Indeed, Money Advice Service has this ‘top tip’ on its website for those interested in Premium Bonds: “Your chances of winning the top prize are very slim – most people will win smaller prizes or nothing at all.”
One important thing to understand here is that because Premium Bonds pay no regular income, any money invested is likely to lose purchasing power to inflation (rising prices) over time if you don’t win a prize. With inflation running at around 2.5% per year, that’s certainly a key issue to keep in mind.
Given the low odds of winning a prize and the lack of inflation protection, Premium Bonds don’t appear to be a smart long-term investment, in my opinion. I believe there are much better ways to achieve financial freedom.
A better way to get rich
One proven investment strategy that’s helped millions of investors across the world get rich in the past, is dividend investing. This is where you invest in companies that pay out a proportion of their profits in cash payments (dividends) to shareholders, and then you reinvest these dividends to buy more stocks, which nets you more dividends. Dividend investing won’t make you rich overnight, yet over the long term, the results can be powerful due to the power of compounding (earning interest on interest). The beauty of dividend investing is that it’s a simple strategy and you really don’t need a lot of money to get started.
Right now, the yields on many UK dividend stocks are high, which is a plus. For example, popular FTSE 100 stocks such as Shell, Lloyds, and Aviva offer yields of 6%, or higher. This means that a £10,000 investment could generate dividends of around £600 or more per year, which could then be reinvested to generate more dividends the next year.
Of course, stocks do have an element of risk because share prices constantly fluctuate. You may not get back what you invested. However, when you consider the generous yields on offer from high-quality FTSE 100 companies, the risk is worth the reward, in my opinion.
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Edward Sheldon owns shares in Royal Dutch Shell, Aviva, and Lloyds Banking Group. The Motley Fool UK has recommended Lloyds Banking Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.