Premium bonds have been around since 1956, with hundreds of millions of people earning billions of pounds between them.

But how do they actually work and are they a worthy investment?

Here’s everything you need to know.

What are they?

Premium bonds are an alternative to a bank account as a place to invest your money in exchange for a return.

While money in a savings account accumulates interest at a set rate a year, premium bonds are entered in a monthly draw, which randomly gives out prizes worth between £25 and £1m.

You can invest any amount in premium bonds between £25 and £50,000.

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Government loan in exchange for cash prizes

A bond is effectively a loan invested in a government or corporation.

As such, when you buy a premium bond, you are lending that money to the government to help with its finances.

Premium bonds are managed by an organisation called National Savings & Investments (NS&I), which was established in 1861 as the Post Office Savings Bank.

It started out as a way of ordinary people being able to invest their money safely, while helping the government at the same time. Now around 24 million people have premium bonds.

While a classic government bond, known as a gilt in the UK, produces a set amount of interest after a fixed period of time, premium bond holders are given the chance to win monthly prizes, which are paid straight into their bank accounts.

How do they work?

NS&I’s “electric random number indicator equipment” or “ERNIE” generates the account numbers of around 5.7 million holders every month who are then awarded a prize.

For every £1 you invest, you have a 21,000 to 1 chance of winning, so the more you invest, the greater your odds.

There is a “prize fund rate”, which represents the average return in prize money holders get in a year.

This changes according to financial markets. It increased five consecutive times, much like the Bank of England’s base rate, in 2023, and is currently at 4.65%, but will fall to 4.4% from March.

This means that the total number of prizes will fall from 5.84 million to 5.77 million – or £4.75m to £4.44m.

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Myron Jobson, senior personal finance analyst at Interactive Investor, explains: “The odds of winning are determined by the total number of bonds held and entered into the monthly prize draw.

“As the prize rate decreases, the total prize fund may also decrease – but this doesn’t necessarily impact the probability of an individual bond winning a prize, as it’s relative to the total pool of bonds in the draw.”

Unfortunately, the chances of winning the two £1m prizes every month are around 60 billion to 1.

Are they better than a savings account?

Historically, people have championed premium bonds for being secure and tax-free.

However, although they are backed by the Treasury, which unlike a bank cannot go bust, all money in UK bank accounts up to £85,000 is now guaranteed by the Financial Services Compensation Scheme, making claims premium bonds are “more secure” largely redundant.

The only difference is that the FSCS could take a week to reimburse you if your bank goes bust.

The idea of “tax-free” prizes is also slightly misleading.

From 2016 the government introduced a personal savings allowance, which means that all interest on savings is automatically tax free.

The only exception to this is if you’re a basic rate taxpayer who earns more than £1,000 a year in interest, a 40% rate taxpayer who earns more than £500 in interest a year, or a top-rate 45% taxpayer.

In this case, premium bonds could be a good way of you earning tax-free cash if one of the above applies to you and you have surpassed your PSA threshold.

Ultimately, some savings account now offer higher interest rates than the premium bond prize fund rate.

And many experts stress that you need better-than-average luck to actually get a rate of return similar to the annual rate.

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Mr Jobson warns: “The fact remains that some savers might be lucky enough to hit the jackpot or win big early on, but others may save and wait for long periods even for a small return, if any.”

So if you’re looking for regular, guaranteed returns, savings accounts or stocks and shares may prove a better choice, he adds.

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