Savings accounts: should you choose monthly or annual interest?
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.
Nearly all savings accounts calculate interest daily. The AER shows savers what they’d earn if the money was left in the account over a 12 month period, so it includes compound interest (in other words interest on your interest).
The gross rate shows the actual interest rate the account would pay today.
Where the gross rate is lower than the AER, it means interest is paid out more frequently – 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 took the money out each month or £20.10 AER, if you took the interest annually.
If the gross rate is higher than the AER, this is a sign that the savings product may offer a bonus for a limited time period.
Savers looking to compare the best products based on rate alone 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 Anna Bowes, director of Savings Champion, explains that the interest amount is the same.
She says: “It wouldn’t make a difference if the interest is paid monthly but rolled over for the year. If there’s no need to have interest paid out to you, choose the annual option as you won’t earn more by choosing the monthly option.”
Why choose monthly over annual interest?
Bowes says one of the key reasons for savers choosing monthly interest over annual is to supplement your 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, but 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 interest will be paid in 2018/19 tax year and you’re already nearing the limit, it may be better to open a product which will pay the interest in the following 2019/20 tax year.
Bowes says: “Some banks pay annual interest on a particular date, whereas others pay it on the anniversary of funding your account.
“If you opened an account today and interest is paid on the anniversary, it would be paid in the 2019/20 tax year. If the interest is paid monthly, then effectively it will be credited within each month until the end of the 2018/19 tax year.
“It’s important to check and be aware of when interest is paid on account, particularly if you complete a tax return.”