Premium bonds are simply savings accounts you can use just like any normal savings account. The difference is that the interest paid on your savings is determined by a monthly lottery.

Savers stand to win anywhere between £25 to £1m tax-free.

So, how do premium bonds work?

If you open a premium bond account you can invest between £100 and £30,000. Savers also get the option to put in £50 a month via direct debit.

In return you’ll receive the equivalent amount in bonds. For example, if you invest £100, you would receive 100 £1 bonds.

The bonds each come with a unique number and are put into the prize draw a month after you’ve bought them. They are entered into the lottery every month until you cash them out again. Each bond is entered individually, so if you buy the minimum £100, you enter the lottery 100 times.

You can buy these bonds online and over the phone from NS&I, at the Post Office, or with a regular monthly payment by standing order.

Anyone over the age of 16 can buy them, alternatively, parents, grandparents and guardians can buy the bonds for those under-16 years of age.

Why do people buy premium bonds?

During financial instability, people tend to flock to bonds and premium bonds are seen to be a ‘safe’ option.

They are government guaranteed, so any money you put into them will be protected by the government and will not be lost. This however does not mean that the effects of inflation will not affect your money.

There is no minimum or maximum time that you have to hold the bonds, so you can cash them in any time after the first month of purchase. It takes roughly 8 days to withdraw the money after you decide to cash out.

How are the winning numbers drawn?

The NS&I uses a machine called ERNIE (Electronic Random Number Indicator Equipment) to generate winning bond numbers every month. The draw is entirely random so it’s impossible to predict the numbers or influence the results.

If you do win a draw, the prize money will benefit from tax-free status. You may opt to re-enter the winnings into the draw in the hope of winning even more, an idea which is supposed to imitate the compound interest you would get on a standard savings account (the interest earned on top of interest already earned over a year).

They sound straight forward, are there any drawbacks to premium bonds?

NS&I markets premium bonds as a lottery that you can win from but this is misleading. Some experts argue that the benefits fail to outweigh the disadvantages of owning the bonds.

A bond holder’s chances of winning the top £1m prize are around 40 billion to 1, odds that make winning the National Lottery seem like a better bet at 14 million to 1.

As mentioned before, your money is not safe from the effects of inflation. This means that the real value of your capital may go down as inflation creeps up. Add to that the fact that you are getting no interest to offset that loss of value you’ll effectively end up with less than you started with.

The lottery payouts are seen as ‘wins’, but if you look at the fact that average savings account is a guarantee of at least an average of 2% (yes this is paltry, but still better than nothing) and with these bonds – unless you win, you get nothing. So in essence, it may work out better to just put your money into a normal savings account and pray for interest rates to go up.

Higher rate taxpayers may want to use these bonds, after you have run out your yearly ISA allowance, as a way to protect your capital.