How To Choose An ISA

Want to open an ISA but not sure which is the best one to go for? Neil Faulkner can help.

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It's more expensive to take out a loan or a mortgage now compared to last summer, but the best savings rates have stayed pretty much the same. Under these conditions, people start saving more and borrowing less.

If you're starting to save, an ISA is a good place to start. It's really quite simple to choose an ISA, but if you're just getting started it's nice to have it explained to you in clear English from an independent source: me!

There are two main kinds of ISA: a cash ISA and a shares ISA. The first, a cash ISA, is a special type of bank account that allows you to earn interest on your savings, free of tax. (Your bank normally deducts income tax from the interest that you earn in your savings account.) The second kind of ISA, a shares ISA, is a way to invest in shares without paying income or capital-gains tax.

Cash ISAs

You should choose a cash ISA if you want a nice safe way to grow your savings pot a little faster than inflation. (Inflation is the rising price of things we buy. Currently, it's reached 5% a year, so you'll only beat inflation if you get a cash ISA that pays more than 5%, such as the HSBC e-ISA, which pays 6.25%.)

It is risky to invest in the stock market, particularly for short periods, so you should choose a cash ISA over a shares ISA if you're risk-averse or unwilling to stash your money away for five or more years. You should also choose a cash ISA over shares if you can't afford to lose the money. Finally, even if you also want to invest in shares, it is wise to have a few months' salary stashed away in a cash ISA - for unknown emergencies!

Many cash ISAs let you put in a lump sum, set up regular payments, or both. The most you can put into a cash ISA in one year is £3,600.

When choosing your first cash ISA, everyone should consider the interest rate. (Currently, 6.25% is the top rate I can find for easy-access ISAs.) Here's what else you should look for in your cash ISA:

• No penalties for withdrawing money.
• A guarantee that the interest rate will stay above the Bank of England base rate (currently 5%) for at least one year.
• No penalty for switching when your deal becomes uncompetitive.

If you don't go for easy access, you could instead choose a fixed rate of interest, but you will probably have to pay penalties if you make withdrawals inside a year or two, so be sure you can afford to lock the money away.

Shares ISAs

If you want to be richer, over longer periods history has shown you can do much better with shares, and therefore shares ISAs can be a really good way to make your money go further.

The thing is that shares are volatile. This means that in the short term they can go down a lot. However, over the longer term, they are likely to go up significantly, leave anyone saving purely in cash ISAs trailing behind.

The investments you pick can have a massive impact on your shares ISA's final performance. Some bets are safer than others.

But if you're reading this and thinking `Uh oh!' because you don't know anything about investing, don't worry. You don't need to be a champion stock-picker, or anything like it, in order to beat the majority of investment funds. And you don't need to spend hours every week researching your investments, or even more than a few hours a year.

This is because you can simply opt for an ISA that tracks a stock market index, called index tracker ISAs. The Fool has long championed these funds based on reams of data and logical reasoning. Even advanced investors who pick shares themselves often have much of their money invested in index trackers.

Here are just some of the things we've written about them over the years:

What Is An Index Tracker ISA?

Index Trackers Versus Managed Funds

Getting Started With Index Trackers

Stupid Humans Versus The Computer

I'd also recommend reading the chapter on index trackers in The Motley Fool's old but bestselling book, The Motley Fool UK Investment Guide (if you can still find a copy).

You can invest up to £7,200 per year in a shares ISA. If you also get a cash ISA then you can't use your full shares ISA limit that year: deduct the amount you invested in the cash ISA from £7,200 to find your new shares ISA limit. (So if you invested £200 in a cash ISA, that would leave you with up to £7,000 to invest in a shares ISA.)

Do we have to use cash ISAs and index-tracking ISAs?

Of course, there are other options, such as savings accounts, picking shares yourself (which you can still put in shares ISAs), or trying to find the fund managers who will give you a better return. That might be exciting for you but, if you're reading an article on how to choose an ISA, I would imagine that you're at beginner level, so it's don't rush in until you know what you're doing. I'm not a total amateur, and yet I use ISAs to save, too!