Are ISA interest compounded?

meggles

i have £3,500 in NS&I ISA.
boyfriend has £3,000 in Barclays's new tax beater ISA.

question- is the interest compounded on a monthly basis?

dunstonh

if the interest is paid on a monthly basis it would be. You earn interest on the interest once it has been capitalised (paid into the account). Whilst it accrues behind the scenes, you are not earning interest on interest.

meggles

so.... £3,000 in barclays at 5.8%.... the actual interest will be depsosited in april 2008 and will be £174.

do i have this right?

dunstonh

Assuming the rate was 5.8% for the whole year and the money is left in there for the whole year unchanged and the interest is added annually, not monthly, then yes you are correct.

oldfella

Barclays is 6.5 annually - so you get £195 - its actually paid monthly and compounded to produce 6.5% over the year

thumshie

E.G.
assuming barclays(5.8% is the NS&I rate) of 6.31%(as AER figures have to be without monthly compounding)
Balance__________montly interest
£3000____________£15.775
£3015.775________£15.85795021
£3031.63295______£15.9413366
£3047.574287_____£16.02516146
£3063.599448_____£16.1094271
£3079.708875_____£16.19413584
£3095.903011_____£16.27929
£3112.182301_____£16.36489193
£3128.547193_____£16.45094399
£3144.998137_____£16.53744854
£3161.535586_____£16.62440795
£3178.159994_____£16.71182463
£3194.871818

6.5% of 3000 is £195, so my calculations are out by 13p but to get my monthly figure i just divided 6.31 by 12....

Sillychuckie

So are you saying an account that pays interest monthly is better than the same account (same rate) paying interest annually?
If you have the choice, you should opt for monthly (since then you are earning interest on the paid interest sooner, rather than having to wait a year)...
That doesn't sound right.

jamesd

Sillychuckie, yes annual is better, by a tiny amount, if you're paying tax on the money. The incentive effect of seeing regular inteest or the earlier availability of the interest may make monthly better for some. Personally I prefer monthly even though I am paying tax.

The difference is the tax on the interest, which loses you the interest compounding on the tax paid each month.

InMyDreams

Sillychuckie wrote: »

So are you saying an account that pays interest monthly is better than the same account (same rate) paying interest annually?
If you have the choice, you should opt for monthly (since then you are earning interest on the paid interest sooner, rather than having to wait a year)...
That doesn't sound right.

You are right. How often the interest is added and compounded does make a difference, and the interest needs to be higher if only added annually. That's why you should always use the AER (annual equivalent rate) to compare interest rates on saving acounts. This tells you what the equivalent rates would be if interest was paid annually and gets over exactly this problem. You will notice that accounts that pay interest annually will have the same AER rate as their actual rate and accounts that pay interest monthly will have a lower actual interest rate, than the AER. Eg 5.75% AER, 5.60% gross. In this case the AER is simply for illustative purposes rather than calculating actual interest, so that you can compare rates more easily. In this example, you are actually only earning 5.6% but the compounding effect means that it is equivalent to earning 5.75% in an account that only pays interest annually.

Jamesd has taken this problem one step further by including tax into the equation, but I'm not sure that's what you were asking about. I'd never really thought about that effect till now. Thanks Jamesd!

Sillychuckie

So.
If you put £100 into a bank account on Jan 1st, at 5%... it will only earn 5% on the £100 until the interest is paid a year later (the following Jan 1st)?

On Dec 31st, the interest gained that night is still only on the initial £100?
Even if interest wasn't actually paid out (shown on the statment), I always thought that the interest earned (calculated daily) was also on previous interest calculated (even if not paid out).

If this is not the case, why do they even bother calculating interest daily?
Surely an easier method would be to simply run an interest calculation only when it is necessary.
e.g. when it is time to payout, when balances change or when rates change.

In my above example, it would reduce 365 calculations down to 1 (on pay day). It would calculate that since my balance hasn't changed since day 1, interest on day 1 (5% of £100) * (number of days unchanged)... = annual interest owed.
This would avoid having to perform the same calculation daily (in this example), which would always give the same figure (assuming interest rates are unchanged).

Alll seems rather illogical to me.
I thought compounding interest was a daily occurance, but really, it only takes effect when whatever is owed is added to your balance.
Hm. learn something every day... (and when you thought you understood it too).

InMyDreams

Sillychuckie wrote: »

If this is not the case, why do they even bother calculating interest daily?
Surely an easier method would be to simply run an interest calculation only when it is necessary.
e.g. when it is time to payout, when balances change or when rates change.

I doubt they do physically do the calculation every day. As you say, why would they? But I've no idea how and when their computers operate so I'd happily stand corrected. Basically all 'calculated daily' effectively means to the man on the street is that the overall interest calculation will take into account exactly what is in the account on every single day of the year. 'Calculated daily' surely seems easier to think about than 'calculated when it is time to payout, when balances change or when rates change'. The actual computer calculation is probably only computed in one go when its actually added, but takes into account the daily balance which is what's important.