Compound interest question - closing account early

clairec666

I generally understand how compound interest works, and the difference between gross and AER if interest is paid monthly.

However I'd like some clarification on how interest is calculated if you close an account early.

Example: I have £1000 in an account earning 5%. If I close the account after exactly half a year, I should be paid half of 5%, i.e. £25.
If I put that £1025 into another account also earning 5% I would earn slightly more interest for the second half of the year, because it's being paid on a higher amount.

If you could genuinely gain money this way, surely everyone would be doing it, so is the interest on closure calculated in a different way to remove the benefit of the extra compounding? I.e. not exactly half of 5%?

(This question was posed to me by a very savvy GCSE student and I genuinely didn't know the answer...)

Emmia

Lots of places will restrict the interest paid if you don't complete the minimum term - so if it's a 12 month product, you need to hold the money for the full 12 months. Not doing so could mean no interest at all.

The bank could also remove options to withdraw generally, perhaps only allowing it on the death of the account holder in the minimum term. 

If you go for easy access savers, then the money could be withdrawn and reinvested as described, but perpetually moving your savings, chasing better rates can also mean you lose a day's interest when the money is moved, which could make gains really quite marginal. Personally I (and I'm sure most people) have better things to do, than chasing a couple of pounds of extra interest that I might get from Bank B over Bank A.

Many of the best rates can either be open only to new customers (you'll be fishing in increasingly smaller pools of being "new") or include a bonus which is only payable after a certain time period of having the money in the account e.g. a year. Rates/accounts might also be restricted to also having a current account with £X per month flowing through it, and potentially also requiring Y direct debits to be paid from the account.

Essentially, it's important to read the T&C's of whatever financial product you sign up to.

clairec666

Emmia said:

Lots of places will restrict the interest paid if you don't complete the minimum term - so if it's a 12 month product, you need to hold the money for the full 12 months. Not doing so could mean no interest at all.

The bank could also remove options to withdraw generally, perhaps only allowing it on the death of the account holder in the minimum term. 

Essentially, it's important to read the T&C's of whatever financial product you sign up to.

Thanks. For the sake of simplicity, and trying to answer my student's question, I'll ignore any accounts with restrictions on withdrawals, and assume the full interest earned is paid on account closure.

(This is just a hypothetical situation, not relating to any of my own accounts)

Found a good thread on this very forum from a couple of years ago, but it doesn't 100% answer my question: https://forums.moneysavingexpert.com/discussion/6520328/interest-calculated-accrued-paid-what-they-all-mean-and-which-is-best

Emmia

Apologies I edited my post to go over instant access accounts too.

Personally I have better things to do than chasing marginal rate increases on my savings. My savings accounts are topped up through direct debits/standing orders and perpetually changing those to new accounts would also be a pain in the proverbial.

Whether closing after 6 months would offer precisely 50% will depend on how the bank calculates interest Vs when the money is moved.

If your student wants to do this, then they can crack on.

clairec666

Thanks for the edit 

I guess you could turn a 5% account into 5.12% by withdrawing every month, and I assumed there would be some people who would do this... however, I agree with you, I have better things to do with my time, and the gain is minimal.

Emmia said:

If your student wants to do this, then they can crack on.

I suspect he will - he's very keen on any kind of money-making scheme. But the novelty will soon wear off!

Emmia

clairec666 said:

Thanks for the edit 

I guess you could turn a 5% account into 5.12% by withdrawing every month, and I assumed there would be some people who would do this... however, I agree with you, I have better things to do with my time, and the gain is minimal.

Emmia said:

If your student wants to do this, then they can crack on.

I suspect he will - he's very keen on any kind of money-making scheme. But the novelty will soon wear off!

A gain also requires a better paying account to be available. That is not always the case.

slinger2

and the worry would be whether you could close one account and open another without losing a day's interest.

The only time it might be useful for me is if I knew I was going to close an EA account early, I'd perhaps go for the annual interest option. However generally it's not worth the hassle

zagfles

clairec666 said:

Emmia said:

Lots of places will restrict the interest paid if you don't complete the minimum term - so if it's a 12 month product, you need to hold the money for the full 12 months. Not doing so could mean no interest at all.

The bank could also remove options to withdraw generally, perhaps only allowing it on the death of the account holder in the minimum term. 

Essentially, it's important to read the T&C's of whatever financial product you sign up to.

Thanks. For the sake of simplicity, and trying to answer my student's question, I'll ignore any accounts with restrictions on withdrawals, and assume the full interest earned is paid on account closure.

(This is just a hypothetical situation, not relating to any of my own accounts)

Found a good thread on this very forum from a couple of years ago, but it doesn't 100% answer my question: https://forums.moneysavingexpert.com/discussion/6520328/interest-calculated-accrued-paid-what-they-all-mean-and-which-is-best

Doesn't it? It goes into great depth on the subject  What is missing? 

Your student is very bright. Hope you've introduced him to the MSE forums!

jim1999

clairec666 said:

I generally understand how compound interest works, and the difference between gross and AER if interest is paid monthly.

However I'd like some clarification on how interest is calculated if you close an account early.

Example: I have £1000 in an account earning 5%. If I close the account after exactly half a year, I should be paid half of 5%, i.e. £25.
If I put that £1025 into another account also earning 5% I would earn slightly more interest for the second half of the year, because it's being paid on a higher amount.

If you could genuinely gain money this way, surely everyone would be doing it, so is the interest on closure calculated in a different way to remove the benefit of the extra compounding? I.e. not exactly half of 5%?

(This question was posed to me by a very savvy GCSE student and I genuinely didn't know the answer...)

It is an interesting hypothetical.

Effectively you're triggering the payment early, forcing an account to pay the gross interest earlier than otherwise expected and boosting the effective AER.

I think the key here is that the difference is fairly slight.

If you take a real world example like this one: https://www.westbrom.co.uk/savings/easy-access/four-access-saver-issue-3 it shows you can choose either annual interest (4.55 gross and 4.55 AER) or monthly interest (4.46 gross and 4.55 AER).

So, if you chose to close and reopen the annual interest version of that account every single month, from a very high level, quick perspective, we're talking about perhaps a 0.1% increase by forcing that monthly compounding.

If you had £10k in the account, that's £10 per year.

However, 

1) you run a high risk of being banned permanently by that bank or building society for wasting their time
2) you will lose days of interest from money being transferred back and forth and having days it doesn't earn interest (which will eat into your returns)
3) you run the risk of that account not being offered any more - if that Issue 3 ceases to exist and is replaced by Issue 4 at 0.25% lower, you'd have been better off just keeping the account.

So I don't think there's a massive trick here that the student has discovered.  In essence a lot of banks / building societies are happy to offer monthly interest if you choose, but for simplicity they'll tend to modify the gross to keep the AER the same.

If you want to exploit that differential, you technically can, but actually compounding isn't as big an effect as people make it out to be so you'd really be wasting your time.

Bear in mind as well, that £10 per year is kind of a best case scenario - monthly compounding, assumes no losses due to days not earning interest etc.  If you did it once or twice a year, you'd be getting an even lower effective benefit.

Certainly an interesting observation by the student though.

clairec666

zagfles said:

Your student is very bright. Hope you've introduced him to the MSE forums!

Might hold off for a while, otherwise he'll get sucked in to in-depth discussions on regular saver funding strategies and will forget to focus on his exams 

zagfles

I'm not sure why banks are still so old fashioned in the way the operate interest, it's probably regulatory or tax reasons. I've noticed if I check my mortgage account, interest applied to the account increases daily. Banks could easily do this with savings accounts, then you'd totally eliminate the differences between monthly paying and annual paying accounts, or wheezes to get a bit more interest based on timing of interest payments, everything would be the same. Interest would accrue continuously at the "force of interest" ie  ln(1+AER)  eg 4.879% for a 5% AER account.