Premium bonds are much like savings accounts, but with one big difference: instead of a reliable interest rate your returns are determined by a monthly lottery.

Every month investors are eligible to win between £25 and £1m completely tax-free.

In May, National Savings & Investments (NS&I), the agency which operates the premium bond scheme, increased the amount savers can invest in the bonds from £30,000 to £40,000 and upped the number of prizes awarded. From August, two premium bond owners a month will take home £1m, twice the previous number.

How do they work?

You can hold between £100 and £40,000 in premium bonds. You also have the option of investing £50 every month with a direct debit.

Every £1 gets you one bond with a unique number, which is then added to a monthly prize draw similar to the lottery.

For example, if you invest £1,000 you have 1,000 separate chances to win. Odds currently stand at 26,000 to one per single bond.

According to moneysavingsexpert.com’s Premium Bond Calculator, an investor with £1,000 is unlikely to win anything, while an investor with £30,000 in premium bonds could expect to win about £350 a year.

You can hold the bonds indefinitely, and the numbers stay in the draw for as long as you own the corresponding bond. While the bonds themselves don’t earn any interest, the prize pot as a whole increases by 1.3 per cent each year.

This rate is set by NS&I and takes into account the needs of its three major stakeholders: customers, taxpayers and the stability of the wider financial markets. The rate last changed in August 2013, and a spokesperson from NS&I told YourMoney.com it is not expected to change “in the near future”.

Premium bonds are for sale at the Post Office or online and over the phone with NS&I. You have to be over the age of 16 to purchase these bonds but anyone can hold them, so they can be a gift for children.

What are the benefits?

Premium bonds are a safe haven in turbulent economic times.

Graeme Clark, head of private clients at Courtiers Investment Services, considers premium bonds part of a client’s emergency fund because they are government backed and relatively liquid.

It usually takes between a few days and a week to cash in premium bonds.

The gains on premium bonds are also tax-free. This goes for £25 prizes and £1m prizes alike.

Clark says the monthly lottery gives these investments the ‘fun factor’. While most people only win between £25 and £50 – and some win nothing at all – the prospect of winning hundreds of thousands of pounds, or even £1m, is understandably exciting, he says.

It also gives rise to some great stories. According to Clarke, one of his clients was just about to cash out his premium bonds and put the proceeds into a savings account when he won £100,000 in the monthly draw.

“It doesn’t happen every week, but it does happen sometimes,” he says.

Premium bonds can also be a great way to teach kids about money, according to financial planner Martin Bamford of advice firm, Informed Choice.

He says: “They offer good financial security, as they are backed by HM Treasury, and importantly they encourage a good savings habit. As investments go, they are mostly harmless.”

What are the downsides?

Unlike a bank account, which guarantees a fixed amount of interest payable each month, premium bonds are more uncertain.

There is no interest paid on these bonds, so there is no way to know if you’ll even beat inflation.

Clark says: “You could be seeing a decrease in your capital over the long-term.”

And, while £40,000 seems like a lot of money, the limit does restrict how useful premium bonds can be for savers over a lifetime.

This is particularly true for investors with very little appetite for risk, who might feel tempted to plough much of their nest egg into these bonds.

Should I invest?

Premium bonds are a great tool for shielding your savings from the tax man if you are a higher-rate taxpayer and do not have any room left in your ISA.

These bonds are also useful holding-pens for capital you intend to invest in equity markets. After all, the bonds are safe and any returns you happen to make are tax-free.

However, if you are someone who prefers to know what kind of returns you are going to get for your money, this probably isn’t the investment for you.

According to Clark, it is a question of comparing what interest rate you can expect from your bank every month to the benefits of these bonds.

This is particularly true when buying premium bonds for your children, according to Anna Bowes, director of savingschampion.co.uk.

She says: “Children’s accounts generally pay more than adult savings accounts. Therefore you may need to weigh up the results on offer versus the chance of winning.”

Clark concludes: “I see premium bonds as one compartment of an overall strategy. It’s very rare that someone would have the majority of their portfolio in premium bonds.”