Personal finance: The best interest rates are in the post

Since the Bank of England was given responsibility for setting interest rates after the last general election, it has nudged the cost of money upward as a means of controlling inflation. This is good news for savers.

However, finding the highest rates of return for your cash is not straightforward. Postal accounts offered by banks and building societies offer some of the best deals but are subject to terms and conditions which need close scrutiny.

Many lenders advertise gross interest payable in bold type but these rates are only available to non-taxpayers. Basic-rate income tax is deducted from interest at source. Non-taxpayers can use an R85 form, available from post offices, to apply for interest to be paid gross.

Basic-rate taxpayers need do nothing but those paying the highest marginal rate will have to declare their income from interest and dividends on their annual tax returns and see their interest further reduced.

Now include the effects of inflation. An account paying 7.5 per cent gross will return 6.0 per cent net to a basic-rate taxpayer and 4.5 per cent net to someone on the higher rate. With inflation at a 12-month average of 3.6 per cent at the end of September, the real income net of inflation from the investment does not leave much room for Christmas spending sprees.

Postal deposit accounts were introduced by Cheltenham & Gloucester Building Society in 1989. According to C&G's Debbie Isaacs, the rationale was simple: "We could offer higher rates by post because accounts did not incur the overheads arising from our branch network.

"Postal accounts do not have the scary connotations that direct and electronic banking hold for many customers," she said.

This may be so, but sifting through fine-print terms and conditions reveals that some of these accounts may carry substantial penalties.

Most accounts offer a choice of monthly or annual interest. Both are variable rates, but monthly interest can be remitted to your current account as income. Annual interest will be credited to your account in arrears over a 12-month period after the day it opened.

Interest on monthly accounts will usually be between 0.25 per cent and 0.5 per cent lower than that available on an annual basis. Choosing the highest rate of annual interest seems like common sense until the costs of early withdrawal are taken into account.

Because interest is paid at the year end, withdrawals must come from the starting balance. Withdrawing amounts from the starting balance may reduce the marginal rate of interest earned on the account.

For example, anyone with pounds 25,000 to invest would choose Yorkshire Building Society, offering 6.80 per cent, against Clydesdale Bank's flat rate of 6.75 per cent. But withdraw pounds 100 and interest payable falls to 6.55 per cent.

Other important differences emerge between account providers. Alliance & Leicester offers competitive rates, but allows only three withdrawals a year, with a minimum pounds 500 for each transaction. Northern Rock also allows only three transactions, but with minimum values of pounds 1,000.

These rates apply to instant access postal accounts. Notice accounts are also available by post, on terms ranging from 30 to 120 days. The number and value of permitted transactions on these accounts will be subject to additional restrictions.

If you have money to go on deposit, postal accounts may offer the best returns, but be sure that the type of account chosen is appropriate to any likely change in your circumstances. Otherwise it could prove more expensive than you anticipated.

- Iain Morse