It's not easy to work out how much interest you'll get from a savings account. We explain about gross rates, net rates and AERs.
Perhaps the greatest love affair on earth is that between financial firms and their jargon. Indeed, in The Devil's Dictionary Of Money, Your Financial Jargon Buster and What They Say - And What They Mean, I warned Fool readers to be very wary of the gibberish and mumbo jumbo which financial companies use as part of their 'confusion marketing'.
As we know, a mug punter who doesn't understand the rules of a gamble is a prime target to be ripped off. Equally, if you don't understand the language of finance, then you're at risk of being taken for a ride. Thus, you need to know at least a little vocabulary before you start shopping around for financial products.
Take, for example, savings accounts. In theory, these should be one of the simplest financial products imaginable. However, in practice, choosing your ideal savings account is a tricky exercise, not least because there are over four thousand accounts to choose from!
In Ten Tricks To Boost Your Savings, I came up with a fistful of ways to improve the returns that you earn from your spare cash on deposit. Below, I go 'back to basics' by explaining the three most popular expressions which you'll encounter when shopping around for savings accounts:
1) Gross interest rate
The gross rate of interest is the rate of interest before tax. Thus, a gross rate of 5% a year means non-taxpayers get £5 for every £100 on deposit. However, in order to be paid gross interest, you need to complete and submit a form R85 to your bank or building society. Without this declaration, your bank will automatically deduct a fifth (20%) of your interest in order to pay savings tax on your behalf. Speaking of tax leads us on to:
2) Net interest rate
The net rate of interest is the rate of interest after tax has been deducted, usually quoted after 20% tax. Hence, for a basic-rate (20%) taxpayer, a gross rate of 5% a year becomes a net rate of 4% a year after savings tax has been deducted.
Although adverts for savings accounts will quote the net rate after 20% savings tax, that's not what higher-rate taxpayers receive. If you pay tax at 40%, you will lose two-fifths of your gross interest to the taxman, so a gross rate of 5% a year becomes just 3% a year after tax. This barely beats inflation (rising prices), which explains the appeal of tax-free savings accounts known as cash mini-ISAs.
Here are two simple rules to work out net rates of interest:
For basic-rate taxpayers: divide the gross annual rate by five and then multiply by four.
For higher-rate taxpayers: divide the gross annual rate by five and then multiply by three.
3) AER (Annual Equivalent Rate)
As well as the gross rate of interest, you'll also see the Annual Equivalent Rate quoted in ads for savings accounts. The AER shows the gross rate after taking annual compounding into account, which is when you earn interest on interest, and interest on interest on interest, and so on.
If your savings account pays interest once a year, then the AER will normally equal the gross rate, because there is no compounding of the interest earned during the course that year. However, if your account pays monthly interest, then leaving that interest in the account each month causes compounding to improve your annual interest rate.
Let me give you an example: an account pays monthly interest at 5% gross a year. Hence, the monthly interest rate is 5%/12, or 0.417% a month. Compounding this over a year gives an annual equivalent rate of (1.00417^12) minus 1 (where '^' means 'to the power of'), which comes to 5.12% AER. So, leaving your monthly interest in this account for an entire year would produce a compounded rate which is the equivalent of 5.12% gross paid once a year. Got that?
Finally, it's worth comparing the gross rate with the AER, because the difference tells you a great deal about the account.
If the AER is lower than the gross rate, then this suggests that the account pays an introductory bonus rate which lasts up to a year. If the AER is the same as the gross rate, then this suggests that the account pays interest once a year (so no compounding of monthly, quarterly or half-yearly interest takes place). If the AER is higher than the gross rate, then this suggests that the account pays interest more often than once a year.
As you can see, saving rates aren't as simple as they first appear. For that reason, please do dig down into the small print of a savings account. Otherwise, you may find yourself facing disappointment further down the line!
More: Use the Fool to find tip-top savings accounts, current accounts and credit cards!