monthly or annual interest

jetski76

Hi, i have found an ISA provider i want to take out but am unsure as to which is the best option to choose from between having my interest paid monthly or annually. Would it be best to have it paid monthly so you then earn interest on your deposit plus interest each month surely?

MarkyMarkD

Firstly, some savings account providers will only allow interest to be paid monthly if it is paid out of the account (i.e. into your current account). This is not a good idea with ISA interest as then you can't earn tax-free interest on the interest.

Secondly, if the savings account provider DOES offer the choice of monthly or annual interest, they normally set the rates such that the effective rate (AER) is the same in any case.

For example, the Barclays ISA is 6.31% tax-free, 6.50% AER. If they offered the choice of monthly interest at 6.31% or annual interest at 6.50%, there's no benefit in taking either as they are both the same effective rate.

carpy

i always thought annual interest worked out slightly better

MarkyMarkD

Some savings account providers do it fairly, others slightly benefit themselves in the calculation (although this is often simply due to rounding).

e.g.

Nationwide 1 year bond - monthly 5.60%, annual 5.75%.

The 5.60% is equivalent to 5.746% which rounds to 5.75%.

Nationwide 1 year fixed ISA bond - monthly 5.70%, annual 5.85%.

The 5.70% is equivalent to 5.851% which rounds to 5.85% but is actually very marginally BETTER than the annual interest rate.

Nationwide Loyalty Tracker bond for £50k plus - monthly 5.15%, annually 5.25%.

The 5.15% is equivalent to 5.273% - LOADS better than the annual interest rate.

So, it's dangerous to make assumptions - better to check the rates - but in general savings institutions don't use this as a way to make extra money.

Nationwide seem to have seriously c**cked up on the third example, as even the AERs shown on their website http://www.nationwide.co.uk/savings/rates.htm show that the monthly interest is a better deal.

SeanW

Annual is better than Monthly in two cases:

1) Monthly compounding effect is reduced if you pay tax out of each month's interest - as this is an ISA, it doesn't matter.

2) If you move money in and out of the account regularly, the compounding effect is reduced again (you earn less than 1/12 of the rate per month, because next months rate includes interest on interest, if you put a massive amount of money in month 12, for example, it would get a less favourable rate than an annual paying account).

MarkyMarkD

Sean

You are right about the tax, although the impact is very small (4.60% net compared to 4.57% net, using the first Nationwide example). Mrs MMD doesn't pay any tax on her savings income (as she earns nothing) so it isn't a problem I think about too often.

I'm not sure that I understand your second point. Obviously if you don't leave the money in the account, you don't get the benefit of compounding, but if you are moving the money elsewhere you are effectively compounding it in the alternative account.

SeanW

Both points results in fairly trivial differences, I was mainly responding to carpy's " i always thought annual interest worked out slightly better".

My second point is like this:

If you put £1 in on 5th April, and £2999 on March 6th, at 6% AER paid monthly by April 5th your balance is approx £3014.65.

If you put £1 in on 5th April, and £2999 on March 6th, at 6% AER paid annually, by April 5th your balance is approx £3016.06.

I get your point if you are moving money between accounts, but if you are paying regularly from salary or lump sump from another source, or withdrawing...

MarkyMarkD

Ah, Sean, I understand your point now.

In fact, it goes further than just annual interest vs monthly interest.

What you are saying is that the effective interest rate is higher than stated, if you open your account/make your large deposit quite close to the annual interest payment date.

AERs assume that the interest is paid exactly a year after the deposit is made (for an annual interest account), or exactly one month after the deposit is made and monthly thereafter (for a monthly interest account) - this means that the AER is actually always slightly higher than quoted, and this difference is bigger for annual interest accounts than monthly interest accounts.

Just to get really numerical, an account paying 6% annually (quoted as 6% AER) actually gives you a return of 6.17% if you open it one month before the annual interest payment date, ASSUMING that you can instantly reinvest at the same rate and do the same 12 times! The reality is that you can't do that, but it means that if you are choosing between two identical, annual interest paying accounts, you should always choose the one which pays the interest first if there is a difference.