Understand the Difference Between AER and Gross Interest on Savings Accounts

When you’re looking for a savings account, you’ll most likely come across the terms AER and gross interest. It might seem confusing at first, but understanding these terms can help you to figure out how much your savings will grow over time.

Both AER and gross interest relate to how much interest you earn on your savings, but they highlight different things. In simple terms, AER takes into account compound interest (earning interest on top of interest), while the gross interest rate doesn’t. AER gives you a more accurate idea of the total interest you’ll earn over a year, factoring in how often it’s paid. Gross interest, on the other hand, is the basic interest rate before taxes or other deductions and is used to calculate your actual interest. Let’s explore these terms in more detail.

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What is Gross Interest?

Gross interest is the total interest rate that a bank or financial institution offers before deductions like tax. It’s displayed as a percentage and represents the actual interest rate applied to your savings over a period.

For example, if a bank offers 3% gross interest on a savings account, this means that you'll earn 3% on the balance before taxes (if applicable) or any other deductions. In the UK, basic-rate taxpayers can earn up to £1,000 in savings interest tax-free, or £500 if you’re a higher-rate taxpayer. If you earn more interest than these allowances, you might have to pay tax on the excess.

Remember, tax treatment depends on individual circumstances and may be subject to change in future.

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What is AER (Annual Equivalent Rate)?

AER stands for Annual Equivalent Rate and reflects how much interest you would earn over a year if the interest is compounded. Compounding means you’re earning  interest on both your original deposit, and any interest that has already been added to your balance. AER provides a more accurate idea of the potential growth of your savings, especially if interest is paid more than once a year.

For example, if your savings account pays interest monthly, the AER shows you what the annual interest rate would be, including the effect of compounding. In contrast, the gross interest rate doesn’t consider compounding.

When interest is paid daily or monthly, then the gross rate is usually less than the AER interest rate.

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Key Differences Between AER and Gross Interest

• Gross interest represents the basic, unadjusted interest rate, while AER shows how growth of your savings, including compound interest
• Gross interest is a simple percentage of how much interest you’ll earn annually, without considering how often interest is paid.
• AER includes the impact of compounding on your savings, making it a more accurate measure of how much interest you will earn in a year if the interest is compounded.
• AER allows for better comparisons between different savings accounts that pay interest at different frequencies, such as daily, monthly, quarterly, or annually, since it accounts for the differences in how often interest is added. 

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Why Does AER Matter?

AER is especially important for comparing savings accounts with different compounding frequencies. If two accounts offer the same gross interest rate, but one pays interest monthly and the other pays annually, the account that compounds interest monthly will offer a higher AER. This is because you’re earning interest on interest through the year, rather than just at the end, and means your money will grow faster, even if the gross interest rates are identical.

Let’s say two accounts offer a gross interest rate of 2%. Account A compounds monthly, while Account B compounds annually. Account A will have a higher AER, which reflects the benefit of earning interest on the interest you’ve already accumulated throughout the year. In contrast, Account B only adds the interest at the end of the year, giving you no chance to earn interest on your interest.

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Which One Should You Focus On?

• If you want to know the actual interest rate being applied to your balance before taxes, focus on the gross interest rate.
• If you're comparing savings accounts and want to understand how much your money will grow over time, focus on AER.

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How to calculate your daily interest

Your interest is calculated and paid daily with our GB Bank Base Rate Tracker, 30-Day and 95-Day Notice accounts. Daily interest is calculated using the gross interest rate, which is currently 4.54%* for our Base Rate Tracker. Remember, the gross interest rate is the flat rate of interest that’s actually paid. 

Daily interest earned is your account balance, multiplied by the gross interest rate, and dividend by the number of days in the year.

So working with an account balance of £10,000, this is what the calculation would look like: 

(£10,000 * 4.54%) / 365 = £1.25 daily interest.

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Conclusion

Both AER and gross interest are important when choosing a savings account, but they serve different purposes. Gross interest shows the basic interest rate you’ll earn before any deductions, while AER gives you a more comprehensive view of how your savings will grow with compounding. When comparing savings accounts, AER is usually more useful, but it’s always essential to consider both rates, especially if taxes or compounding frequency are factors in your decision.

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*17th September 2024