26 November 2014 : 
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Guide to savings accounts

2. Savings accounts and interest rates

Why does money in savings accounts earn interest?

If you have a credit card, loan or mortgage, then you will be used to being charged monthly interest. Banks charge this interest as a fee for lending you money because they ‘borrow’ this money themselves.

Money from savings accounts is used by banks to lend out in the form of loans, mortgages and credit cards. To encourage people to open savings accounts and deposit money, banks need to offer them an incentive so they pay them some of the money they make from borrowers.

How is interest paid?

Banks usually pay interest into your savings account monthly, quarterly or yearly.

The amount you will earn depends on the interest rate of the savings account and also how much money you keep in it. It may also depend on when you last withdrew money from the account and if you did so within the terms and conditions regarding when you can access your money. If you have an instant access savings account you can access your money immediately without being penalised. If you have a notice account, you have to give the required amount of notice to the bank before you withdraw any money. If you don’t give the required notice, you will lose some or all of a set period of interest.

The interest offered on savings accounts is related to the level of access you will have to the account.

The longer you are willing to leave your money untouched, the higher the interest rate you are likely to be given. This is because the bank knows that it has your money to lend out for longer and can reward you accordingly.

How is interest worked out?

Gross per annum (gross p.a.)

The amount of interest you receive will be worked out as a gross per annum percentage. ‘Gross’ means before tax has been deducted and ‘per annum’ means each year.

Annual Equivalent Rate (AER)

The amount you will be given for any money held in a savings account is presented to you as a percentage Annual Equivalent Rate (%AER).

The AER is given to demonstrate what your interest return would be if the interest was compounded and paid annually instead of any other period (e.g. monthly).

Advertisements for interest-bearing savings accounts will quote the AER so that you can use it as a means for comparing accounts. This way you will be able to see which account will give you the best return.

If, for example, an account pays interest monthly, then the AER is calculated by adding each interest payment to the deposit and then calculating the next interest payment from the newly calculated deposit figure. This is called compounding the interest.

This means that accounts that earn interest quarterly will have a slightly higher AER than the gross rate because the AER will include the compounded interest over the three months within the quarter.

The gross AER is the contractual rate of interest that you will be paid before income tax has been deducted. The net AER is the amount of interest you will receive after allowing for the deduction of tax.

Fixed interest rate

If you have a fixed interest rate on your savings account then you will have the same interest rate for a fixed amount of time.

Variable interest rate

If you have a variable interest rate, then the account provider can either increase or decrease your interest rate. If your interest rate falls significantly below the base rate then banks will need to inform you of this change with enough notice to give you the opportunity of shopping around for a better deal.

Tracker interest rate

Banks will offer you an interest figure based on the Bank of England base rate. If this goes up then it is good news for savers. If it goes down (which happens less), it means that banks will probably lower your savings account interest rate.

Which is best: a fixed or a variable rate?

Having a fixed interest rate is a gamble in some senses but in other ways it provides more security than having a variable interest rate.

You will be better off if interest rates on other accounts fall. However, you will be stuck with a poor rate if interest rates increase. Banks usually penalise you if you try to switch to another account while you are still in a fixed rate deal.

Inflation

When you are choosing a savings account remember to consider the effect of inflation* on your money.

Make sure you choose an account with an after-tax AER that at least matches inflation or your money will decrease in value over each year and you will be able to buy less with it.

*Inflation currently stands at 2.2% (as at February 2008)

How is the interest on my savings calculated?

To work out how much interest you will earn on your savings we need to take you back to sums you will have encountered in GCSE Maths.

Example 1: Savings account with 5.25% gross AER p.a. and deposit of £1,000

1. Divide the interest rate by one hundred: 5.25 ÷ 100 = 0.0525
2. Add one: 0.0525 + 1 = 1.0525
3. Multiply by the amount in the account: £1,000 x 1.0525 = £1,052.50
4. Interest earned (before tax) = £1,052.50 - £1,000 = £52.50

The amount of interest you have earned in Example 1 above is gross. To work out how much interest you will get added to your account after tax has been deducted you will first need to understand how tax rules apply to savings.


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