Confused over monthly or annual savings interest? Here’s what you need to know
Whether a bond, easy access account or cash ISA, you may find the savings product you choose offers two separate rates – an AER (Annual Equivalent Rate) and/or a gross rate.
As an example, the previous market-leading Santander easy access savings account offered 2.75% AER but 2.72% gross.
Nearly all savings accounts calculate interest daily and savers may be given the choice in frequency of when this interest is received. The AER shows you what you would earn if the money was left in the account over a 12 month period. This means it includes compound interest – interest on your interest.
Meanwhile, the gross rate shows the actual interest rate the account pays today.
Where the gross rate is lower than the AER, it means interest is paid out more frequently. This could be monthly or quarterly rather than annually.
For example, you may see a savings product offering 1.99% gross but 2.01% AER. If you have a £1,000 deposit, you would earn £19.90 gross if you take the money out of the account each month or £20.10 AER, if you wait and take the interest annually.
If the gross rate is higher than the AER, this is a sign the savings product may offer a bonus for a limited time period, Anna Bowes, director of Savings Champion reveals.
She says that for anyone looking to compare the best products based purely on rate, they should use the AER figure.
If a savings product has the same rate for both the gross and AER figure, for example 2%, it simply means the interest is paid annually.
Here savers may think that if they choose the monthly (gross) option and have the interest rolled over within the account for a year rather than withdraw the interest, they will earn more.
But Bowes explains that the interest amount is the same.
She says: “It wouldn’t really make a difference if the interest is paid monthly but rolled over for the year. In some cases it may increase the return if this option is available, but really by pennies and a few pounds, depending on the amount deposited.
“But, unless you actually need to spend the income, don’t have interest paid out to you; choose to have the interest paid to you at the end of the term, or once a year as you’ll earn less by not allowing the money to accrue and compound.”
The table below reveals the interest earned per year if interest is paid out monthly (withdrawn), vs the interest earned per year if it is paid out monthly:
Why choose monthly over annual interest?
Bowes says one of the key reasons for savers choosing monthly interest over annual is to supplement income.
“A time to choose monthly interest is if you need to take interest out to spend it, otherwise choose the annual option and the interest will be added at the end of 12 months,” she says.
Another reason which could dictate whether you opt for monthly or annual interest relates to the Personal Savings Allowance (PSA), which was introduced in April 2016.
Any savings earned in banks, building societies, NS&I products, company bonds and credit unions won’t be taxed up to a certain threshold, depending on your marginal rate of income tax.
Basic rate (20%) taxpayers can earn up to £1,000 of savings income, higher rate (40%) taxpayers have a £500 PSA, while additional rate (45%) taxpayers aren’t eligible.
Any interest above the PSA is taxed and for savers who are close to breaching the allowance, the monthly or annual interest option may better suit your circumstances.
If you choose the monthly option, interest will be paid in the 2022/23 tax year so if you’re already nearing the limit, it may be better to open a product which will pay the interest in the following 2023/24 tax year by choosing the annual option.
Bowes adds: “Some banks pay annual interest on a particular date, whereas others pay it on the anniversary of funding your account.
“If you open an account today and interest is paid on the anniversary, it would be paid in the 2023/24 tax year. If the interest is paid monthly, then effectively it will be credited within each month until the end of the 2022/23 tax year and then into the following tax year.
“It’s important to check and be aware of when interest is paid on account, particularly if you complete a tax return.”