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Annual Interest versus Monthly Interest?

24

Comments

  • david78
    david78 Posts: 1,654 Forumite
    bigwoman,

    Very roughly, £25000 invested at 4% net (5% gross) should give an income of about £83 per month.
  • System
    System Posts: 178,157 Community Admin
    10,000 Posts Photogenic Name Dropper
    No wonder poor Judi is confused!

    Beleive me, it doesnt take a lot!!!
    Very roughly, £25000 invested at 4% net (5% gross) should give an income of about £83 per month.

    Blimey its not a lot is it? Some poor sod has slogged his guts out to earn that £25000 to get a measly £83 a month interest.

    The reason i like monthly interest added to my savings is because i like to see how much interest i am gaining per month. I keep thinking i ought to put it in a higher interest account but i cant work out the interest that would have accrued (blimey where did that word come from? :o) on a monthly basis. Is there a calculation that would help me so that i wouldnt lose heart?
  • Joe_Bloggs
    Joe_Bloggs Posts: 4,535 Forumite
    It is so easy to fritter money away with bank charges and interest rate charges that can rival 25K of savings interest for a month.
    (blimey where did that word come from? )
    According to the beeb it came from God Blind Me to Cor Blimey etc. The referenced site mentions asterisked out swearwords.
    http://www.bbc.co.uk/dna/h2g2/A753527
    J_B (At yer service ma'am)
    PS It's accrual world in the savings business.
  • Milarky
    Milarky Posts: 6,356 Forumite
    Part of the Furniture 1,000 Posts Photogenic
    But Judi's observation shows the 'logic' of keeping the interest on OPM ('other peoples' money) via 0% credit cards - opps other board!

    In an ideal world, we wouldn't have any 'savings' just huge amounts of borrowed money on which we earned a bit of the interest.

    Now the fact that the current 'bit-rate' is only about 4% after tax (0.25% per month) at best is surely a reflection of the other fact which cannot have escaped our notice, which is that banks have so much money that they have to 'pay us' to take it, so to speak..

    It's better to be earning a poor return on OPM, than am 'honest buck', surely? This way, if you need more income just 'borrow' more money at any rate less than 4%... ;D
    .....under construction.... COVID is a [discontinued] scam
  • david78
    david78 Posts: 1,654 Forumite
    Totally agree. We should be making as much interest on our savings as we can and making as much interest on other peoples money as we can.

    Not sure what formula Judi is looking for. If you open an account which pays interest annually, the interest you expect is:

    amount on depost X 0.8 X interest rate in % / 100

    X = times
    / = divide.

    If you want to get a very rough idea of how much is accruing per month just divide by 12.
  • System
    System Posts: 178,157 Community Admin
    10,000 Posts Photogenic Name Dropper
    Not sure what formula Judi is looking for. If you open an account which pays interest annually, the interest you expect is:

    amount on depost X 0.8 X interest rate in % / 100

    X = times
    / = divide.

    If you want to get a very rough idea of how much is accruing per month just divide by 12.

    Thats what i wanted to know. Thanks David.
  • MJSW
    MJSW Posts: 171 Forumite
    I fear Judi may become even more confused once she's read this!  ;D
    All that matters is the AER. Two accounts with the same AER (one paying interest monthly, one annually) will both pay out the same net interest and will both pay the inland revenue the same tax provided the interest is retained in the account.
    Sorry this is wrong. It is only the gross rates that compound to be equivilent. This is comfirmed by the definition from the British Banking Association: "The Annual Equivalent Rate is a notional rate quoted in advertisements for interest-bearing accounts which illustrates the contractual (gross) interest rate (excluding any bonus interest payable) as if paid and compounded on an annual basis." (from http://www.bba.org.uk/bba/jsp/polopoly.jsp?d=135&a=1575 )

    It is mathematically impossible for both the gross and net AERs for the monthly and annual accounts to be the same as each other (unless either the tax rate or the interest rate is 0%). If the gross AERs are the same, the net AERs have to be different. The net rate will always compound to slightly lower figure. I have a first class degree in mathematics, and would be very interested to see your calculations if you believe that the net AERs can possibly be identical at the same time as the gross AERs being identical.

    The other thing you need to understand is the circumstances in which the rates will be equivilent. Because of the way an AER is defined, they are only equivilent if the the money is left intact for 12 months, and the balance never increases or decreases (apart from the interest credits). I shall demonstrate this with a simple (  :o ) example (I've ignored tax). Suppose A opens an annual interest paying 5% annually on 1 Jan 04. B opens a monthly account paying an an AER of 5%, which makes the monthly rate 4.89% (figures derived from ING). If both deposit on 1 Jan and leave the money to compound gross for 12 months, then the final balances will be the same. But suppose both put £0.01 in there for 11 months, and then at the start of month 12 deposit £99,999.99 (extreme example I know, but it illustrates the point!).

    In month 12, A earns £100,000x5%x1/12=£416.66.
    In month 12, B earns £100,000x4.89%x1/12=£407.50.

    Interest is added to both accounts on 31 December (being the end of the year for A, and the end of the month for B). On that date A, has a balance of £100,416.66, but B only has £100,407.50. Essentially B has lost out on his compounding. If the money is in place for a year, B is compensated for his lower rate by the monthly compounding. But in the example above, he has received no compunding because he received no interest on which to compound during the first 11 months. So the rate, which were apparently equivilent, are in fact not equivilent.

    It is a common misconception that annual equivilent rates are always equivilent - they are not (as the example demonstates). The monthly and annual interest will generally only be identical if:

    1) The interest rolls up gross, and
    2) No deposits or withdrawals are made from the account, and
    3) Interest on the annual account is paid 12 month after the opening date (if it is paid sooner, then again annual will beat monthly).

    Otherwise the figures will be different, although I stress again the differences will usually be relatively small and unlikely to be worth worrying about. By the way, I'm not necessarily saying than monthly interest will always be worse than annual interest. There are circumstances in which monthly interest will work out better (generally where the balance is reducing over the year).
    When you get interest monthly, it is not correct to say that 20% tax has been taken from each gross monthly payment. Just enough tax is deducted so that the amount compounds and adds up to 20% tax for the year as a whole.
    Really? Perhaps you should tell the Inland Revenue so that the bank in question can be prosecuted! When a bank or building society pays interest it is obliged to deduct lower rate tax under ICTA1988 (unless it is an ISA or the saver has registered for gross interest). If they deduct either more or less than 20% (subject to rounding to the nearest penny) they are breaking the law. Can you give me a single example of a bank which has deducted less than 20% on a monthly interest payment?  Do you have any links to any websites which confirm that banks use this procedure?

    In any evernt, it would be mathematically impossible to adjust the tax deducted from monthly interest as you describe. The only way this could be achieved is by deducting no tax at all from the monthly interest and paying it all at the end. Unless the full gross payment is credited to the account each and every month without any deduction of tax at all, then it is a mathematical certainty that the net balance after 12 months will be lower than with annual interest (although as I said before these differences are very small). In fact you would pay slightly less tax with monthly interest (because you would earn slightly less interest).
    This is why with savings accounts which pay interest monthly the tax is not included on monthly statements, but is only shown on your annual statement (usually sent out after the end of the tax year).
    All the monthly interest accounts I have, apart from Ing, show the tax deduction every month, and it is always 20%. Even with Ing you can even track the gross interest, as the statement tells you the gross interest earnt in the calendar year to date. If you deduct the net interest credited to the account in the same period, that gives you the tax deducted to date. This will be 20% of the gross interest.
  • @MJSW
    I'm glad that the bba link was only a partial illustration
    to AER and not the complete explaination.
    How does one compare an AER on a monthly interest paying account with an AER on an annually paying interest account ? The comparison is at the end of the first year,  assuming the same initial deposit of capital and no interest is withdrawn on the monthly account. Neglecting tax of course. If it's a few tens of pence in a £1000 then don't bother.
    J_B.
    PS The interest on many accounts is calculated daily and the net results displayed monthly.
             
  • System
    System Posts: 178,157 Community Admin
    10,000 Posts Photogenic Name Dropper
    Ok. maybe it would be easier if i asked how much interest a month i would get with £1500 at 5.50% ???
  • MJSW
    MJSW Posts: 171 Forumite
    The comparison is at the end of the first year, assuming the same initial deposit of capital and no interest is withdrawn on the monthly account. Neglecting tax of course. If it's a few tens of pence in a £1000 then don't bother.
    For starters, it probably will only be a few tens of pence per £1000, but I'll do it all the same!

    If you ignore tax and the interest on the annual account is paid after 12 months, the interest will be the same (ignoring the odd bit of rounding in the interest calculations). That is the whole point of the AER, it gives the equivilent rate if the gross interest compounds over a year. But in practice, most people won't get the gross rate compounding, they will only get the net interest compunding.

    I'll try and demonstate how to work it out using Ing's current rate. The gross AER rate is 5%. If you put say £10,000 in an annual account at 5%, you would get £500 interest, or £400 after tax, in 12 months time.

    Firstly, I'll look at where the monthly interest is paid gross. The gross flat rate at Ing is 4.89%. Each month you get 0.4075% (4.89/12). After month 1, you have a balance including interest of 10040.75 (you get this by mutliplying the balance by 1.004075). Month 2 is 10040.75x1.004075=10081.66. Multiply by a 1.004075 a further 10 times, and that will give you the balance at the end of 12 months. Shortcutting this, just type (1.004075^12)x10000, on a calculator, where ^ is to the power of (usually xy on a calculator). The final balance is actually 10500.11 (slightly higher due to rounding of the interest rate by Ing; the theoretical monthly rate should be 4.8889%, but they round it to the nearest 0.01% ie to 4.89%).

    Now with net interest, the monthly net rate paid by Ing is 3.91%. Each month, net interest of 0.3258333% (3.91/12) is added to the account. So after 12 months, you have (1.003258333^12)x10000 = 10398.08, ie £1.92 less than you would have received with annual interest at the same AER.

    That is with basic rate tax only. If the saver is a higher rate taxpayer, this difference will be larger, as tax payments on part of the interest are accelerated by 12 months. Suppose I open an account on 1 July 04. With annual interest paid on anniversary, the first interest would be paid 30/6/05, ie the 05/06 tax year. With monthly interest, 9 months worth would fall in 04/05 tax year. The higher rate tax liability on those 9 months falls 12 months earlier than it would have with annual interest. In this example, the higher rate tax liability accelerated would be approx £75. Paying that tax 12 months earlier than otherwise costs you around £3.75 (gross) in lost interest.

    Tax is just one of the differences, but differences will also be created by further deposits or withdrawals during the year, and by changes in interest rates.
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