Question of the week: Why do savings accounts pay more interest annually than monthly

Former_MSE_Andrea · 20 January 2009 at 7:50PM

Why do savings accounts pay more if you get interest annually than monthly?

They don’t pay more, they're just listed as a higher rate for example a 5% AER (annual rate) will be a 4.89% monthly. In fact the amount you get will be identical. The difference is all due to how compound interest is calculated.

It's important to remember both rates are the amount of interest earned a year. When you're paid interest monthly, the rate given is calculated as if you withdrew the money straight away, so there’s no interest earned on the interest.

Yet when you earn interest annually, the rate you get includes the effect of interest on the interest as it's accrued over the year, so it is higher.

Either way, unless you take the interest out each month, you will have the same amount in the account at the end of the year, so it makes no difference which option you choose. See Top Savings and How Interest Works guides.

If you'd like to discuss this click reply below.

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bullivants · 21 January 2009 at 2:05AM

It can be beneficial to opt for monthly interest. Many accounts have tiered interest arrangements, and interest at the end of month 1 could push you from one tier to the next. In the 4.89/5.00% example quoted, savings of £9960 would accrue interst in month 1 of £41, with the effect that interest for month 2 would be paid on £10001 - quite handy if the bank quote a 0.2% higher rate kicking in for balances in excess of £10K.

denisiw · 21 January 2009 at 10:49AM

I opted for monthly interest when I was with Icesave as I wanted to see how much interest was being added. I was also of the opinion that once it was added to my total they wouldn't be able to take it off me!

Denis

Consumerist · 22 January 2009 at 2:54AM

MSE_Andrea wrote: »

Either way, unless you take the interest out each month, you will have the same amount in the account at the end of the year, so it makes no difference which option you choose.

This is true if you do not pay tax and have your interest paid gross by the bank.

If, however, your interest is not paid gross then it's actually the monthly tax deductions which make the difference.

If interest is paid monthly, the bank deducts the tax due on the gross interest you've earned in the last month before adding the net interest to last month's balance. The advantage to the bank is that no further interest is paid on the tax which has been removed from the ongoing balance each month.

You do get slightly more by having interest paid yearly and so does the taxman. The extra is at the expense of the bank because it continues to pay interest on the tax element throughout the year.

The following table shows how interest accumulates over a year.

£10,00 deposit at 6% p.a. nominal rate ( 0.5% gross per month ) – interest re-invested

The annually-paid gross interest gives the AER = 100 x £616.78 / £10,000 = 6.1678%

As can be seen from the example in the table, yearly net interest is £493.42 compared with £490.70 when interest is paid monthly.

Question of the week: Why do savings accounts pay more interest annually than monthly

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