What are AER and gross interest rates?

We explain the difference between the two rates and what they can tell you about the return on your savings.

Updated on 19 May 2015.

Thoughtful businessman sat at desk

What is the AER?

AER stands for Annual Equivalent Rate. It shows you how much interest you would earn if you left your savings in an account to accumulate a year's worth of interest.

As money will accumulate a certain amount of interest every month it is left in an account, over the course of a year you end up earning interest on top of that interest. This is known as compound interest. The figure quoted as 'AER' on a savings account is calculated from the rate of interest earned over a year, including this compounded interest.

What's the difference between the AER and the advertised rate?

Some savings accounts allow you to choose how often to have your interest paid - monthly, quarterly, or annually. The AER will be the same whichever option you choose, but the advertised rate (which doesn't take into account compounding) will be lower the more frequently interest is paid.

For example, if you had an account with an AER of 3%, its advertised rate for interest paid annually would also be 3%, but for interest paid monthly this would be more like 2.8%.

The AER simply takes into account the standard interest rate over a year - and as interest paid at the end of a year would have compounded interest added onto that, it will usually be higher than the actual annual rate without compounding (many savings accounts don't compound interest annually but rather pay it out every month/quarter).

In this way AER gives you a true picture of how much interest you would earn on your money if you saved with a particular account. The higher the AER, the better the return on your savings.

AER is also a useful figure for comparing one savings account with another, because it gives you a standardised figure that is used the same way across all savings products. Therefore by looking at the difference between AERs when comparing savings accounts you will be able to make an informed decision about which account will make your money work harder.

What is the gross rate?

The gross interest rate on your savings, just as anything else in the financial world labelled gross, simply means the amount you would get before tax is deducted.

For most UK taxpayers tax is deducted automatically from interest earned, before it is even added to your balance, as it counts as a form of income. Therefore most of us will see 'net interest' noted on our statements instead of a gross amount (that is, unless you aren't a taxpayer and therefore can fill in an R85 form to prevent your interest from being taxed).

The gross rate shows the flat amount of interest you would be paid over a year, without taking into account interest earned on top of interest (compound interest). Therefore it gives you an idea of what the interest rate on your account would be 'on the whole', before tax and before compounding.

What is the difference between the two?

If interest is only added to your account annually, there will be no added compounded interest to include in the calculation of the AER. And as AER is quoted before tax just as gross is, this means that the AER and gross rate would be the same in this case.

If however interest is added to your account monthly and the AER must include this compounded interest, it will be higher than the gross rate. This is because the AER will have the extra compounded interest added to its total, whereas the gross is only the flat annual amount.

What are they used for?

AER is the most useful figure to look out for when comparing savings accounts. It is the equivalent of an APR on debts because it gives a complete representation of how much you would earn (or in the case of APR, pay) in interest over a year.

The gross on the other hand can be used to compare the 'behind-the-scenes' aspect of savings accounts because it shows the flat rate of interest, before tax and without taking into account any compounded interest.

If you are comparing savings accounts for a longer term investment, then the AER is what you should use as your benchmark for deciding which account is more competitive than another. Remember however that if you are planning to leave your money in an account long-term, you should review the AER offered regularly as it may become less competitive over time.

What is net interest?

If you are a taxpayer, any interest paid on your savings will have tax deducted before it is credited to your account. For basic rate taxpayers, this will be 20% of any interest earned, and 40% for higher rate taxpayers. The amount left over after tax has been deducted is referred to as net interest.

What about introductory bonuses?

If you are planning to keep your savings in an account short-term, for example to take advantage of an introductory bonus before moving on, different factors come into play. Depending on how long you intend to stay with your new account, you should look to either the AER or gross to know how much interest you will be earning.

If the introductory bonus is for a year or more, and you're planning to keep your money in that account for the duration of the bonus period, it is best to look at the AER to give you a true annual picture of interest rate. However if the bonus period is only 6 months or so, and you intend to move your money after this time, the AER loses relevance.

This is because the AER shows you what you could expect to earn if your left your money in that account for a year. If you know you're only staying with the account for 6 months or so, you'll be better off looking to the gross rate earned instead.

Whenever comparing savings accounts remember that it is crucial to always compare like with like. This means that you should compare the AER of one account with the AER of another, and the gross with gross. If you compare a quoted AER figure with a gross figure on another account, you will be left with a skewed picture of what return you can really expect on your savings.

Written by at money.co.uk

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