AER vs Gross

Innys

This question has probably been asked a hundred times before, but I'll ask it again.

When considering savings products, should I be swayed by the AER or the gross interest rate? I am a taxpayer.

Thanks

I

Chrismaths

AER. This is what you will receive in interest over one year (gross).

Limes

Both rates are useful.

AER = Rate that you would receive at the end of 1 year if interest was compounded.

Gross = Initial rate payable excluding any deductions for tax.

As a tax payer it would possibly be useful to look at the net rate - depending on if you are a normal or higher tax payer.

e.g.
An account which might have an initial gross rate of 4.41% might have an introductory bonus of 0.5% for the first 6 months. In this case the which would mean that for the last 6 months of the year the gross rate would be reduced by 0.5% to 3.91%. If this was the case the AER on this account would be 4.16%.

An account without an introductory bonus which paid interest on a monthly basis with a gross rate of 4.41% would end up with a 4.50% AER or if paid annually would be 4.41% AER.

So you see in these examples there are three different AERs which could be shown for an accounts that appear to have the same Gross rate. Not overly helpful!

In my mind the Gross rate has always been a good starting point to get at an initial idea of rate but in conjunction with the AER can tell you a lot about the frequency of interest payments, any introductory bonus offers and any effects once this bonus has been removed.

Of course the AER doesn't tell you about the tax implications - not necessarily in any case, but the long and the short of it is that I wouldn't just focus on one rate as a prefeence to the other.

Chrismaths

An account which might have an initial gross rate of 4.41% might have an introductory bonus of 0.5% for the first 6 months. In this case the which would mean that for the last 6 months of the year the gross rate would be reduced by 0.5% to 3.91%. If this was the case the AER on this account would be 4.16%.

An account without an introductory bonus which paid interest on a monthly basis with a gross rate of 4.41% would end up with a 4.50% AER or if paid annually would be 4.41% AER

Which shows why the AER is the one to look at. An account that pays monthly will have a lower gross rate than an equivalent annual payer, but the interest earned over one year will be identical. If you go out beyond one year, you could get a 5 year bond that pays 5% gross at maturity. Sounds good, but you only end up with the same as an annual payment of 4.56% gross or a monthly payment of 4.47%. All these accounts would have an AER of 4.56%.

Paul_Herring

Chrismaths wrote:

AER. This is what you will receive in interest over one year (gross).

The problem with this is, the AER assumes you don't pay tax.

By all means use it to compare products, but don't assume it will bear any resemblance to the final interest you'll get after that year. For example ICICI's 5.03% Gross does indeed work out to 5.15% AER when compounded monthly (as they advertise), but only if you don't pay any tax. If you pay tax at 20%, it works out at 4.1% (£4.099 per £100 saved per year) - almost, but lower than, 80% of the AER.

Chrismaths

Fair enough, but the difference is negligible - Take an account paying 5% gross monthly (AER: 5.116%). You'll get 4.074% net of BR tax. Take an account paying 5.116% gross annually, and you'll get 4.093% net. On £10,000 that's a difference of £1.90 over a year. So it's not perfect - but it's a great deal closer than looking at gross rates. Anything else is semantics in my opinion.

Paul_Herring

Chrismaths wrote:

Fair enough, but the difference is negligible - Take an account paying 5% gross monthly (AER: 5.116%). You'll get 4.074% net of BR tax. Take an account paying 5.116% gross annually, and you'll get 4.093% net. On £10,000 that's a difference of £1.90 over a year. So it's not perfect - but it's a great deal closer than looking at gross rates. Anything else is semantics in my opinion.

I make the difference between AER and what you get after basic rate tax to be £104.21 over the year on £10,000 (this was the point I was trying to make originally - the last comment about being almost 80% of AER was just a throwaway remark )

Chrismaths

Oh. In which case you will notice I said "gross" after my first post.