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AER and the income from savings

Last Edit: 27/06/18

AER (Annual Equivalent Rate) -- sometimes referred to as the Annual Effective Rate -- is a formula for calculating the amount of interest that will be earned if a principal sum is saved for one year. The formula for AER is as follows: (1 + i/n)n - 1 (i = interest rate) (n = number of times interest is paid during one year). AER is applied to saving accounts offered by UK banks and building societies.

AER factors in compound interest: which means that two saving accounts can have the same rate of gross interest (say 2%) but have a different AER. This is due to compound interest: where interest is added to the principal sum (original balance saved) and then interest will be earned on the interest that has been added to the principal sum. Therefore an account that compounds interest more times during one year -- but has the same gross interest rate -- will have a higher AER, because interest is being earned upon interest. That is why the formula for AER has a component within it that inputs the number of times interest is paid during one year.

The purpose of AER is it allows people to compare saving accounts/investments which differ in the way they compound interest: for example, accounts which compound monthly, or quarterly, or annually. By placing an AER percentage upon all of these accounts, it gives consumers a true reflection of the returns of each account. While AER is a reliable tool for comparing saving accounts, it does not calculate the tax paid on savings income: the Net rate of interest is the interest you will receive after tax. Since the 6th of April 2016, UK savings interest has been paid as a gross rate -- which means that tax is not been paid on the interest. Gross and net rates of interest are not a good way to compare saving accounts, because they do not take compound interest into account.

When comparing saving products -- based on the AER they are offering -- it should also be noted whether the account offers a variable AER or fixed AER. Variable means that the AER on the account can change at any point due to the Bank of England's base rate or if the bank/building society decides to do so. Saving Bonds on the other hand, unlike regular saving accounts, usually offer a fixed AER, but with the drawback that the money can usually not be accessed as easily.