Quick understanding required

ian-d wrote: »

So in terms of the example I gave, both being the same account with monthly interest, which is correct?

Savings Account (AER) 6.55% (GROSS) 6.36% (NET) 5.09%
Savings Account (AER) 6.55% (NET) 5.24%

Finally, don't suppose you have any links to understanding AER versus GROSS, I don't understand it...and maybe shouldn't

Guide to AER / Gross here :-

http://www.moneysavingexpert.com/banking/interest-rates#AER

On your question. I suspect you're wrong that both rates apply to monthly interest? The latter (AER and Gross both 6.55%) is clearly (as earlier post) for annual interest. So both calculations are correct - and both Net figures are calculated (less 20% Savings tax) by multiplying the Gross (6.36% and 6.55% respectively) by .80.

I always thought that interest net of tax was based on Gross - 20% (or 40% depending).

Is that not correct, is net actually based on AER - 20% (or 40% depending)?

In which case, and maybe I shouldn't ask in fear of being confused further, how come companies offer 12 month fixed bonds at 7.15% AER and 7.15% Gross, and 36 month fixed bonds at 7.15% AER and 7.67% Gross?

Unless I'm greatly mistaken, the gross is the amount of interest you'd earn as a percentage of your original investment if you withdraw your interest immediately upon payment, so that it does not get reinvested.

This means that for accounts where interest is paid annually, the gross and the AER will be the same. For accounts where interest is paid more frequently than once a year, the gross will be lower than the AER, and accounts where interest is paid less frequently than once a year, the gross will be higher than the AER.

For example, assuming you didn't have to pay tax, then in that three year bond you mention, the Gross of 7.67% means that when the interest is paid, you will get 7.67% of your original investment for each year that the money has stayed in - in other words, £7.67 for each year for each £100, or £23.01 for the full three years for each £100.

Why is this equivalent to an AER of 7.17%? Because if you had an account whose gross rate was 7.17%, but which paid interest annually, and you reinvested each interest payment, then the amount of compounded interest you'd end up with after the full three years would also be £23.01 for each £100.

The purpose of the AER is to help you compare the interest rates of different savings products that may have a different interest payment frequency on a like-for-like basis. However, the figure that the bank actually uses to calculate the interest is the gross rate.

But what about tax? You ask if tax is based on the Gross or the AER - in fact it's not based on either. The tax is based only on the actual amount of the interest payments, regardless of how the interest is calculated, and regardless of how frequently the interest payments are made. So, if you become entitled to an interest payment of £100, then tax will be 20% of that, meaning that you will get paid only £80 interest. Simple as that.

If your savings account pays interest monthly, then tax will also be deducted monthly. This means that if your savings account offers a choice between yearly and monthly interest payments, and the before-tax AER is the same whichever payment frequency option you choose, then, assuming you pay tax at 20%, you would be fractionally better off by having interest paid yearly rather than monthly. But if you don't have to pay tax, it won't make any difference.

Clearly Kaupthing have worked it on GROSS minus TAX equals NET, whilst Thisismoney have worked it on AER minus TAX equals NET. So which one is right? I only care for the rate I actually get, calculated on a monthly basis!

If KTE's advertised Gross rate is 6.36%, and they pay interest monthly, then this means that the interest paid each month is 0.53% of your balance - that's one twelfth of the annual gross rate. 20% tax is deducted, which means that the amount of interest paid monthly net of tax will be 0.424% of your balance. If this payment is left in the account and interested is compounded over the whole year, then after a year, your balance will have grown by 5.208% - rounded to the third digit. I have calculated this by multiplying 1.00424 by itself twelve times (there's twelve months in a year).

So - where do KTE get the 5.09% figure from? Well - 0.424% times twelve is 5.088%, which KTE have rounded up in their literature. What that means is that if you took out your net interest each month, then, after a year, you'd have taken out about £5.09 for each £100 in your account. But you'll earn further interest on these payments if you don't withdraw them.

As for Thisismoney's figure of 5.24% - I'm afraid that's simply wrong. It's only slightly wrong, though, but it looks like they've made some oversimplifying assumptions in how they have calculated it. You can't calculate how much interest net of tax you will receive just by taking 20% off the AER if an account pays interest more than once per year; the tax for each interest payment needs to be calculated separately.

Hope that helps. Please note that I may have got any or all of this completely wrong!