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Fixed rate savings: monthly or annual interest?

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Written by: Paloma Kubiak
19/01/2018
If you’re looking to lock your savings in a fixed rate product, you may need to decide between monthly or annual interest.

There are pros and cons of either decision but one of the main differences is the interest rate offered.

If you opt for a fixed savings account paying interest monthly, then the interest rate is typically lower than that offered on the annual or anniversary interest version.

As an example, a £10,000 deposit to Paragon Bank’s five-year fixed rate bond offers 2.37% (gross, 2.40% AER) paid monthly. But if as savers opt for the interest to be paid annually, the rate rises to 2.40% (gross/AER). Annual interest is normally paid at a higher rate because of compounding – instead of paying out monthly the interest can roll up with the sum invested.

By opting for the monthly interest at the end of the five-year term, you’ll have earned £1,256.75 interest on your initial £10,000 deposit. By choosing to have the annual interest applied, you’ll get £1,259.

While the difference seems like peanuts, the monthly interest rate option can be good for those looking for a steady income stream.

Paragon, for example, allows savers to have their interest paid into the fixed rate saver, to another Paragon account or to a nominated account that has been set up (as long as interest is £1+).

Therefore, it’s wise for savers to check that the chosen account allows the interest to be paid elsewhere. Some products require you to compound any interest earned, so in this case, they wouldn’t be suitable for income generation.

Data site Moneyfacts says if you’ve a significant savings pot, you may want to use it to supplement your income. Rachel Springall, finance expert at the site, says: “Savers would be wise not to neglect the option of monthly interest, as interest is applied on the balance and any other interest earned, and the longer it’s left compounding, the better.

“With a fixed rate bond, savers would typically leave any investment untouched until its maturity, so it’s a good opportunity to take advantage of monthly interest – especially if savers have a large cash investment.”

However, she adds that getting an account that compounds interest (annual interest option) is likely to be more of a fruitful return overall.

She says: “It’s likely savers will notice a distinct difference between the returns offered on a monthly interest bond versus a standard bond that pays on its anniversary. Due to this reason, savers would be wise to work out how much they could earn in interest on both options and be sure that they are prepared to leave the investment untouched.”

A way to do this is to look at the gross rate rather than the AER for comparison. Another point of note is on the Personal Savings Allowance (PSA) which was introduced in April 2016.

It’s a government measure designed to reduce the amount of tax people pay on their savings income. Basic rate (20%) taxpayers who earn up to £45,000 are able to earn up to £1,000 of savings income without any tax being due. Higher rate (40%) taxpayers who earn up to £150,000 get a £500 PSA. But additional rate taxpayers (45%) who earn above £150,000 aren’t eligible for the PSA.

Springall says: “Keep an eye on the interest earned so that the Personal Savings Allowance isn’t breached.”

Best fixed rate bonds

Moneyfacts has compiled the best fixed rate bonds paying monthly interest versus the rates they pay on anniversary (click to enlarge):

monthlyvsannual

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