Shopping around for the best saving account has never been easier. Variety of products tailored to every taste, myriads of comparison sites providing impartial and unbiased market information, all nicely presented and simple to grasp. The only thing left to do is to pick up the account with the highest interest rate and reap the rewards. Well, not quite. There is a lot more to it and understanding how the interest rates work can help you make better informed decisions in the future.
When comparing two different saving accounts some kind of interest rate yardstick is needed. It is generally accepted that AER, which stands for annual equivalent rate, should be quoted on all adverts for saving accounts. It is designed to allow easy comparisons as it is meant to smooth out the variances between accounts. Think of it as the equivalent of the APR for debts. AER assumes that interest is paid annually and lets you compare not just the amount of interest but also how often it is paid. As can be expected, the higher the AER, the greater the return on your savings.
Having said that, you must remember that AER is dependent on how often your interest is paid – monthly, quarterly or yearly. For example, a savings account with and AER of 5% paid yearly will yield 5% return but the monthly option with the same AER will only generate 4.89% each month. This is because the interest credited every month will itself earn extra interest during the rest of the year, thus increasing the return. To make these two products equal we need to apply lower gross rate for the monthly saving account.
To complicate matters further, bonus interest rates can also affect AER. If a bonus is being paid for six months, then the AER will be lower than the gross rate for the first six months as it would need to incorporate the periods before and after the bonus was paid. Knowing that can be quite useful when switching to different savings accounts once the bonus rate has ended. At this stage AER is irrelevant and the only thing you want to know is the gross rate during the bonus period to compare against the other products.
Confusing as it may seem at first, it is a relatively basic concept. And practical too! Not only safeguarding the customers against unfair marketing ploys such as promotional offers that disappear after a few months, but also giving them a better idea of what their actual returns would be in the long term. However, if you are still in some doubt remember to always compare ‘like with like’, this should be your starting point.