Interest calculated, accrued, paid - what they all mean and which is best

zagfles

RG2015 said:

@spider42

Once again, many thanks.

Can I ask your opinion on why the banks would allow a strategy that in effect lost them £62.50?

I had assumed that they would migigate against such an outcome by applying a monthly/gross interest rate equivalent for an account closure before the annual interest payment date.

Remember it's only £62.50 on the assumption of the ridiculously large deposit of £100k, in reality virtually nobody's going to have £100k in a single account, even if they did have that much in cash, it's above the FSCS limit.

It's only 0.06% gain, if someone wanted to chase an extra 0.06% interest they wouldn't be doing this, they'd be monitoring the best buy rates and shifting money whenever there's a better rate, there's always going to be a new account paying a tenth of a percent more interest in the next 6 months. 

spider42

zagfles said:

AER is also supposed to account for cashflow where that's known. I remember being confused by a regular saver account which paid interest annually at 6% nominal but the AER was something like 6.1%. Reason was the mandated cashflow on the account meant the balance was higher when nearer to the interest payment date. AER is more complicated than simply accounting for compounding. 

Agreed, although the circumstances when that will apply are extremely rare. The guidance on regular savings accounts states: "Where regular monthly savings products are advertised which have a limited life of one year and interest is only credited once a year the AER should not take account of any interest earned after the account matures. The AER will be the same as the nominal rate for the account."

So your scenario should only arise where there are mandated deposits required as a condition the account, no early withdrawals are permitted, and the account has a life of more than a year. All of the annual paying regular savings accounts I've just looked at (top 30 regular savers on Moneyfacts) all have an AER equal to the gross rate.

RG2015

zagfles said:

RG2015 said:

@spider42

Once again, many thanks.

Can I ask your opinion on why the banks would allow a strategy that in effect lost them £62.50?

I had assumed that they would migigate against such an outcome by applying a monthly/gross interest rate equivalent for an account closure before the annual interest payment date.

Remember it's only £62.50 on the assumption of the ridiculously large deposit of £100k, in reality virtually nobody's going to have £100k in a single account, even if they did have that much in cash, it's above the FSCS limit.

It's only 0.06% gain, if someone wanted to chase an extra 0.06% interest they wouldn't be doing this, they'd be monitoring the best buy rates and shifting money whenever there's a better rate, there's always going to be a new account paying a tenth of a percent more interest in the next 6 months. 

I completely agree with what you are saying, but it is the principle of the anomaly.

I know that the example was used to demonstrate a point and is highly unlikely to be used by anyone, for many reasons.

One could equally say that Ford Money pay 4.60% for the annual option and 4.51% for the monthly option. A difference of only 0.09%.

And finally back to the original question, there are many reasons for choosing monthly or annual interest. But very few people would even consider making their decision based upon which gave the better return.*

* excluding tax considerations.

zagfles

spider42 said:

zagfles said:

AER is also supposed to account for cashflow where that's known. I remember being confused by a regular saver account which paid interest annually at 6% nominal but the AER was something like 6.1%. Reason was the mandated cashflow on the account meant the balance was higher when nearer to the interest payment date. AER is more complicated than simply accounting for compounding. 

Agreed, although the circumstances when that will apply are extremely rare. The guidance on regular savings accounts states: "Where regular monthly savings products are advertised which have a limited life of one year and interest is only credited once a year the AER should not take account of any interest earned after the account matures. The AER will be the same as the nominal rate for the account."

So your scenario should only arise where there are mandated deposits required as a condition the account, no early withdrawals are permitted, and the account has a life of more than a year. All of the annual paying regular savings accounts I've just looked at (top 30 regular savers on Moneyfacts) all have an AER equal to the gross rate.

I suspect they changed the rules because it was causing confusion. The account I was talking about was about 20 years ago, but pretty sure it was a one year account. I can just imagine typical bank staff trying to explain why the AER is greater than the nominal rate on an annual interest account 

Nationwide "start to save" accounts are 2 years, but it wouldn't have applied to them as they're not technically regular savers as they don't have a mandatory monthly deposit, just a monthly deposit limit (of course anyone optimising them would use them as a regular saver). 

zagfles

RG2015 said:

zagfles said:

RG2015 said:

@spider42

Once again, many thanks.

Can I ask your opinion on why the banks would allow a strategy that in effect lost them £62.50?

I had assumed that they would migigate against such an outcome by applying a monthly/gross interest rate equivalent for an account closure before the annual interest payment date.

Remember it's only £62.50 on the assumption of the ridiculously large deposit of £100k, in reality virtually nobody's going to have £100k in a single account, even if they did have that much in cash, it's above the FSCS limit.

It's only 0.06% gain, if someone wanted to chase an extra 0.06% interest they wouldn't be doing this, they'd be monitoring the best buy rates and shifting money whenever there's a better rate, there's always going to be a new account paying a tenth of a percent more interest in the next 6 months. 

I completely agree with what you are saying, but it is the principle of the anomaly.

I know that the example was used to demonstrate a point and is highly unlikely to be used by anyone, for many reasons.

One could equally say that Ford Money pay 4.60% for the annual option and 4.51% for the monthly option. A difference of only 0.09%.

And finally back to the original question, there are many reasons for choosing monthly or annual interest. But very few people would even consider making their decision based upon which gave the better return.

Really banking is quite old fashioned based on the way they used to have to do things before computers. These days really they should have daily or even continuously compounding accounts, then it really would make no difference. Interest would accrue daily or even continuously at the "force of interest" ie natural log of (1+rate)

spider42

RG2015 said:

zagfles said:

RG2015 said:

@spider42

Once again, many thanks.

Can I ask your opinion on why the banks would allow a strategy that in effect lost them £62.50?

I had assumed that they would migigate against such an outcome by applying a monthly/gross interest rate equivalent for an account closure before the annual interest payment date.

Remember it's only £62.50 on the assumption of the ridiculously large deposit of £100k, in reality virtually nobody's going to have £100k in a single account, even if they did have that much in cash, it's above the FSCS limit.

It's only 0.06% gain, if someone wanted to chase an extra 0.06% interest they wouldn't be doing this, they'd be monitoring the best buy rates and shifting money whenever there's a better rate, there's always going to be a new account paying a tenth of a percent more interest in the next 6 months. 

And finally back to the original question, there are many reasons for choosing monthly or annual interest. But very few people would even consider making their decision based upon which gave the better return.

Tax will usually be the biggest factor, and more important than minor differences between the amount of monthly and annual interest. If you were expecting to not pay tax on the interest in the current tax year (e.g. through spare personal allowance, savings rate or savings allowance), but expected to pay tax in the following year, then you would want to receive interest in the current tax year rather than the next tax year. So a monthly account would be more tax efficient, as some of the interest will paid paid in an earlier tax year.

If the tax situation was reversed (would be liable for tax in the current year, but not in the following year), then an annual account would be better, as it pushes more interest into a later tax year. But this also depends on the specifics of each account, as some pay annual interest on the anniversary of opening and some pay on a fixed date, e.g. 31 December.

Similar issues arise where you expect to change from basic to higher/additional, or vice versa.

But even if you expect to pay the same rate of tax in all years, timing of interest can still make a surprising difference to the returns. Let's suppose you are a 40% taxpayer, and have used the savings allowance already.

Same £100k account, with 5% interest, and let's suppose it pays interest on the anniversary of opening.

Open an account on 5/4/24, and you get £5,000 interest on 5/4/25 - taxable in 24/25 tax year. Open the same account on 6/4/24 and the interest is paid 6/4/25 - taxable in the 25/26 tax year.

The tax liability on the £5,000 interest is £2,000 at 40%. So by delaying the account opening by a day, you are delaying the £2,000 tax payment by a year. The interest you would earn by keeping the £2,000 tax in your own account for an extra year at 5% is £100. On the balance of £100,000, the £100 additional interest you've earned is equivalent to an additional 0.1% return.

With a monthly account, you are generally accelerating some of your interest payments into an earlier tax year than would be the case with an annual paying account. The tax therefore has to be paid sooner, which means you have less money on which you can be earning further interest.

zagfles

spider42 said:

RG2015 said:

zagfles said:

RG2015 said:

@spider42

Once again, many thanks.

Can I ask your opinion on why the banks would allow a strategy that in effect lost them £62.50?

I had assumed that they would migigate against such an outcome by applying a monthly/gross interest rate equivalent for an account closure before the annual interest payment date.

Remember it's only £62.50 on the assumption of the ridiculously large deposit of £100k, in reality virtually nobody's going to have £100k in a single account, even if they did have that much in cash, it's above the FSCS limit.

It's only 0.06% gain, if someone wanted to chase an extra 0.06% interest they wouldn't be doing this, they'd be monitoring the best buy rates and shifting money whenever there's a better rate, there's always going to be a new account paying a tenth of a percent more interest in the next 6 months. 

And finally back to the original question, there are many reasons for choosing monthly or annual interest. But very few people would even consider making their decision based upon which gave the better return.

Tax will usually be the biggest factor, and more important than minor differences between the amount of monthly and annual interest. If you were expecting to not pay tax on the interest in the current tax year (e.g. through spare personal allowance, savings rate or savings allowance), but expected to pay tax in the following year, then you would want to receive interest in the current tax year rather than the next tax year. So a monthly account would be more tax efficient, as some of the interest will paid paid in an earlier tax year.

If the tax situation was reversed (would be liable for tax in the current year, but not in the following year), then an annual account would be better, as it pushes more interest into a later tax year. But this also depends on the specifics of each account, as some pay annual interest on the anniversary of opening and some pay on a fixed date, e.g. 31 December.

Similar issues arise where you expect to change from basic to higher/additional, or vice versa.

But even if you expect to pay the same rate of tax in all years, timing of interest can still make a surprising difference to the returns. Let's suppose you are a 40% taxpayer, and have used the savings allowance already.

Same £100k account, with 5% interest, and let's suppose it pays interest on the anniversary of opening.

Open an account on 5/4/24, and you get £5,000 interest on 5/4/25 - taxable in 24/25 tax year. Open the same account on 6/4/24 and the interest is paid 6/4/25 - taxable in the 25/26 tax year.

The tax liability on the £5,000 interest is £2,000 at 40%. So by delaying the account opening by a day, you are delaying the £2,000 tax payment by a year. The interest you would earn by keeping the £2,000 tax in your own account for an extra year at 5% is £100. On the balance of £100,000, the £100 additional interest you've earned is equivalent to an additional 0.1% return.

With a monthly account, you are generally accelerating your interest payments into an earlier tax year than would be the case with an annual paying account. The tax therefore has to be paid sooner, which means you have less money on which you can be earning interest.

And if you understand that you'd also understand that paying 40% tax on interest is barking mad when you can get around 4% tax free capital gain on low coupon short dated gilts with no limit 

spider42

zagfles said:

spider42 said:

RG2015 said:

zagfles said:

RG2015 said:

@spider42

Once again, many thanks.

Can I ask your opinion on why the banks would allow a strategy that in effect lost them £62.50?

I had assumed that they would migigate against such an outcome by applying a monthly/gross interest rate equivalent for an account closure before the annual interest payment date.

Remember it's only £62.50 on the assumption of the ridiculously large deposit of £100k, in reality virtually nobody's going to have £100k in a single account, even if they did have that much in cash, it's above the FSCS limit.

It's only 0.06% gain, if someone wanted to chase an extra 0.06% interest they wouldn't be doing this, they'd be monitoring the best buy rates and shifting money whenever there's a better rate, there's always going to be a new account paying a tenth of a percent more interest in the next 6 months. 

And finally back to the original question, there are many reasons for choosing monthly or annual interest. But very few people would even consider making their decision based upon which gave the better return.

Tax will usually be the biggest factor, and more important than minor differences between the amount of monthly and annual interest. If you were expecting to not pay tax on the interest in the current tax year (e.g. through spare personal allowance, savings rate or savings allowance), but expected to pay tax in the following year, then you would want to receive interest in the current tax year rather than the next tax year. So a monthly account would be more tax efficient, as some of the interest will paid paid in an earlier tax year.

If the tax situation was reversed (would be liable for tax in the current year, but not in the following year), then an annual account would be better, as it pushes more interest into a later tax year. But this also depends on the specifics of each account, as some pay annual interest on the anniversary of opening and some pay on a fixed date, e.g. 31 December.

Similar issues arise where you expect to change from basic to higher/additional, or vice versa.

But even if you expect to pay the same rate of tax in all years, timing of interest can still make a surprising difference to the returns. Let's suppose you are a 40% taxpayer, and have used the savings allowance already.

Same £100k account, with 5% interest, and let's suppose it pays interest on the anniversary of opening.

Open an account on 5/4/24, and you get £5,000 interest on 5/4/25 - taxable in 24/25 tax year. Open the same account on 6/4/24 and the interest is paid 6/4/25 - taxable in the 25/26 tax year.

The tax liability on the £5,000 interest is £2,000 at 40%. So by delaying the account opening by a day, you are delaying the £2,000 tax payment by a year. The interest you would earn by keeping the £2,000 tax in your own account for an extra year at 5% is £100. On the balance of £100,000, the £100 additional interest you've earned is equivalent to an additional 0.1% return.

With a monthly account, you are generally accelerating your interest payments into an earlier tax year than would be the case with an annual paying account. The tax therefore has to be paid sooner, which means you have less money on which you can be earning interest.

And if you understand that you'd also understand that paying 40% tax on interest is barking mad when you can get around 4% tax free capital gain on low coupon short dated gilts with no limit 

Yes, agreed.

ColdIron

RG2015 said:

I have also been confused by the interest rates being quoted as AER/Gross.

For example, AER 6.17% / Gross 6.00% for the NatWest digital regular saver. Gross to me has always meant before tax as opposed to net after tax.

It depends upon the context, gross and net are used with reference to pay, tax etc but no one uses gross and net in terms of interest these days now that banks no longer withhold tax

The term gross makes no sense when all it means is not AER.

Sometimes gross is the same as AER, e.g. accounts paying annually

Gross is the contractual rate, what they actually pay you. AER is what you might achieve

TheLittleThings

Thank you all!!!! I finally get it!