5-year ISAs: Compound interest or not?

Silver66

Hello,

I'm planning to open a 5-year fixed term cash ISA. According to the MSE website, the best interest rate is with United Bank UK, at 2.65%. I was just filling out their application form when I noticed that the interest has to be paid out to a nominated account if I want it paid monthly or annually. The interest is only added to the ISA itself if I ask for it to be paid on maturity. I'd never come across this before with long-term ISAs. I read some of the small print, and found out that the gross interest if paid at maturity would be 2.79%. However, the interest would not be compounded each year.

Does this mean that I would get less interest overall than if I applied for a 5-year ISA at a lower rate where the interest is compounded (e.g. Shawbrook Bank, at 2.3%)?

This is the first time I've looked into compound interest, and I find it quite confusing that each bank seems to have a different stance on it.

Many thanks if anyone can help.

Zanderman

Silver66 wrote: »

Does this mean that I would get less interest overall than if I applied for a 5-year ISA at a lower rate where the interest is compounded (e.g. Shawbrook Bank, at 2.3%)?

No.

£1000 at simple interest of 2.65 gets you 26.50 per year. Over 5 years that's 132.50 in interest.

£1000 at compound interest of 2.3% for 5 years totals 1120.41 on a quick calculation, so only 120.41 in interest.

The figure you've quoted of 2.79% overall for 5 years IS compound interest though (a compounded 2.65%) so I'm not sure what you're worried about. As long as you don't withdraw the interest it will be compounded.

Edited to add: I just looked at their website and they say:

Interest is not added to your principal amount at the selected frequency unless you have selected interest payment at maturity.

Which simply means you have to select 'interest payment at maturity' if you want it compounded

Audaxer

That seems strange. If I invested £10k in that 5 year Cash ISA, I'd expect £265 to be added to the £10k at the end of year 1, so the next year it works out at 2.65% on £10,265. At maturity I have worked out that the total interest you should have received is £1,397.11 meaning I would expect the total maturity value to be £11,397.11. I would double-check the small print and it if doesn't compound the interest I would forget it.

I would also check that the bank is covered by the Financial Services Compensation Scheme.

Zanderman

Audaxer wrote: »

That seems strange. If I invested £10k in that 5 year Cash ISA, I'd expect £265 to be added to the £10k at the end of year 1, so the next year it works out at 2.65% on £10,265. At maturity I have worked out that the total interest you should have received is £1,397.11 meaning I would expect the total maturity value to be £11,397.11. I would double-check the small print and it if doesn't compound the interest I would forget it.

I'm not getting what is strange?

The bank is suggesting people can take interest out to another account - monthly or annually. In which case it won't be compounded, as the invested cash stays the same.

They are also suggesting people might want to have the interest 'paid at maturity' i.e. not take out during the 5 years. In which case it IS compounded.

Your figure of 11,397.11 is the compounded version - effectively 2.79% - which is what the OP has been quoted (although the OP seems to thinks, wrongly, that this rate , effectively 2.79 over 5 years, is not the effect of compounding)

Audaxer

Zanderman wrote: »

I'm not getting what is strange?

It just seemed strange to me as any Fixed Rate Cash ISA I've had over the years has automatically compounded the interest.

ValiantSon

Audaxer wrote: »

It just seemed strange to me as any Fixed Rate Cash ISA I've had over the years has automatically compounded the interest.

It does, unless you choose to have your annual interest paid into a different account.

capital0ne

What seems strange to me is to waste your ISA allowance on a product that doesn't keep up with inflation.

You do know you can earn £1,000 or £500 if a higher rate tax payer, of interest tax free?

eskbanker

capital0ne wrote: »

What seems strange to me is to waste your ISA allowance on a product that doesn't keep up with inflation.

It might - obviously none of us knows what inflation will do over the next five years, but CPI* was last reported at 2.5% so the ISA is ahead at the moment....

* Other inflation figures are of course available, but arguably the only one that really matters is OP's personal rate, rather than a nationally-calculated average.

grey_gym_sock

capital0ne wrote: »

You do know you can earn £1,000 or £500 if a higher rate tax payer, of interest tax free?

when you get to a largish income, that's meaningless because it would be such small single digit percentage of your total income

capital0ne

eskbanker wrote: »

It might - obviously none of us knows what inflation will do over the next five years, but CPI* was last reported at 2.5% so the ISA is ahead at the moment....

No one knows where inflation is going, with oil heading to $100/barrel who knows, but it's summer so heating oil consumtion will be down, but new MOT is going to fail more diesel cars so maybe car sales/repairs will be up .........nothing is certain, so.....

TSB bank is offering 5% after their IT debacle, and it's not just temporary, I have the promise off their web page saved for future reference! Regular savers pay 5% and so on....., so maybe a 5 yr ISA isn't a good idea right now, but it's better than doing nothing.

eskbanker

capital0ne wrote: »

No one knows where inflation is going, with oil heading to $100/barrel who knows, but it's summer so heating oil consumtion will be down, but new MOT is going to fail more diesel cars so maybe car sales/repairs will be up .........nothing is certain, so.....

TSB bank is offering 5% after their IT debacle, and it's not just temporary, I have the promise off their web page saved for future reference! Regular savers pay 5% and so on....., so maybe a 5 yr ISA isn't a good idea right now, but it's better than doing nothing.

I'm not saying that the 5-year ISA is a good idea (and there are clearly products with higher rates but with various limitations on balances, deposits or durations), but was just correcting the assertion (presented as fact) that it "doesn't keep up with inflation" when it might.