Finance > Banking 101
How Interest Rates Work When Saving
When you have a savings account with a bank, you are loaning the bank your money in return for interest. This article will mainly focus on the Annual Equivalent Rate (AER).
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What is the Annual Equivalent Rate?
AER is the interest rate you will earn for your savings over 12 months. AER takes into account bonuses, compound interest, whether your interest is paid monthly or yearly, the whole lot, so it’s a good way to compare rates between accounts if you’re saving for a 12 month period.
Warning!
If you’re saving for less than 12 months, AER becomes irrelevant, and you should compare the ‘gross’ rate. For example, you may choose to open an account due to an attractive three-month bonus period and then jump ship. If this is the case, you need to consider the interest during that bonus period and the frequency in which interest is paid, i.e. monthly or yearly, to compare deals. Due to AER being calculated over a full 12 months, it won’t give you an accurate rate of return.
- What Does 1% AER Mean for My Savings?
If your bank’s savings account has an AER of 1%, if you keep your money in the account for 12 months, you will earn 1% on your savings.
Example:
If you have £1,000 within the account for a whole year, you will have £1,010 at the end of the year.
£1,000 + 1% = £1,010
You have your original £1,000, plus £10 of interest.
If you save for shorter or longer periods of time, your returns will vary due to compound interest.
- Is AER Different to APR?
Whilst AER is used to represent interest you’ll earn from savings, APR represents the cost of borrowing.
Both are official rates, so for a 12-month comparison of savings, compare AER figures and for a 12-month comparison for the cost of borrowing, compare APR figures.
Will I Be Taxed on My Interest?
The answer to this question depends on the tax band you fall into and the amount of interest you earn.
Everyone gets a ‘Personal Savings Allowance’ (PSA), and the amount you get depends on the tax band you fall in. The more you earn, the less tax relief you get on your interest.
The table below highlights the PSA for each band.
| Tax Band | PSA |
|---|---|
|
Basic Rate |
£1,000 |
|
Higher Rate |
£500 |
|
Additional Rate |
£0 |
For example, given an interest rate of 0.2%, a basic rate taxpayer would need £500,000 of savings to utilise their £1,000 PSA.
£500,000 + 0.2% = £501,000
For this reason, the majority of us will not pay tax on the interest we earn on our savings.
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