ISA that pays monthly interest or ISA that pays yearly. Which pays out more?

Jumping_Bean

Title says it all really.

If I was to put £1000 in 2 ISAs with the same AER - 1 that pays interest monthly and 1 that pays interest yearly - Which account would I have more money in after a set period of time?

I've read conflicting views:

One camp says that it makes no difference to the actual amount of interest paid. The only difference being that the interest is added to the account yearly or on account closure, but the amount added will be the same as with a monthly account.

The other camp says that the monthly accounts pay more because the interest is compounded monthly rather than yearly. Which means one would be earning "interest on interest" right after month one.

Can someone give me a definitive answer please?

Lokolo

If the AER % is the same then it doesn't matter. The gross % will be different.

If the gross % are the same then go for monthly. Usually its something like 6.31% monthly. 6.5% annual with 6.5% AER. Where 6.31% monthly is the same as 6.5% yearly.

Jumping_Bean

So am I right in thinking that the interest is still compounded month on month (with a yearly account) but is only calculated once a year or when closing the account?

jem16

Jumping_Bean wrote: »

So am I right in thinking that the interest is still compounded month on month (with a yearly account) but is only calculated once a year or when closing the account?

Interest is calculated daily but only applied once a year.

Lokolo

Jumping_Bean wrote: »

So am I right in thinking that the interest is still compounded month on month (with a yearly account) but is only calculated once a year or when closing the account?

No.

AER = Annual Effective Rate.

If its monthly or yearly it doesn't matter, the AER rate is the rate you would get if you left your money in your account for 1 year. The actual monthly rate you would get if lower than yearly if the AER is the same for both.

jamesd

Inside a cash ISA it makes no difference whether it's annual or monthly. Outside a cash ISA it does make a difference because you pay tax on the interest each month with the monthly so you lose out by the compound interest on the tax paid. Unless you're getting interest outside the ISA gross because your income is below your personal allowance.

madonss

jamesd wrote: »

Inside a cash ISA it makes no difference whether it's annual or monthly. Outside a cash ISA it does make a difference because you pay tax on the interest each month with the monthly so you lose out by the compound interest on the tax paid. Unless you're getting interest outside the ISA gross because your income is below your personal allowance.

Can you clarify that a bit please?
My thought is that given the same Gross rate, the monthly option must be better regardless of the ISA status.

If the AER is the same, as previous posters have said, the Gross rate of the monthly will be lower but the total interest will be the same.

For example £1000 at 5.5 gross gives me a calculated £44.89 monthly total versus £43.99 annual. Not a huge difference I admit, but it's in favour of the monthly option.

If the interest is only added annually, then your daily calculated interest for the entire 365 days is on the same balance. (i.e 365 days on £1000, then 20% tax deducted when they actually credit the account with the interest)

If, however, the interest is paid monthly then from month 2 you are earning interest on the initial balance plus the net interest and so on. (31 days on £1000 =£4.67 Gross less 20% tax gives £3.74 net credited to your balance so the next month you are getting interest on £1003.74)


Happy to be corrected if I've got the wrong end of the stick BTW!

Lokolo

madonss wrote: »

Can you clarify that a bit please?
My thought is that given the same Gross rate, the monthly option must be better regardless of the ISA status.

For example £1000 at 5.5 gross gives me a calculated £44.89 monthly total versus £43.99 annual. Not a huge difference I admit, but it's in favour of the monthly option.

If the interest is only added annually, then your daily calculated interest for the entire 365 days is on the same balance. (i.e 365 days on £1000, then 20% tax deducted when they actually credit the account with the interest)

If, however, the interest is paid monthly then from month 2 you are earning interest on the initial balance plus the net interest and so on. (31 days on £1000 =£4.67 Gross less 20% tax gives £3.74 net credited to your balance so the next month you are getting interest on £1003.74)


Happy to be corrected if I've got the wrong end of the stick BTW!

If it is gross then you are correct. However, I think you will find that the rate is the same on AER and different on gross.

madonss

Lokolo - You type faster than me, I'd just read my post and decided to put in an extra line saying exactly that.

AER the same = same interest for both.
Gross the same = more interest monthly

Lokolo

madonss wrote: »

Lokolo - You type faster than me, I'd just read my post and decided to put in an extra line saying exactly that.

AER the same = same interest for both.
Gross the same = more interest monthly

Yeh I am not really doing anything at the moment apart from refreshing the Savings Forums

But that is correct. Usually banks will change the monthly gross so that the AERs are the same :-)

Jumping_Bean

Lokolo wrote: »

No.

AER = Annual Effective Rate.

If its monthly or yearly it doesn't matter, the AER rate is the rate you would get if you left your money in your account for 1 year. The actual monthly rate you would get if lower than yearly if the AER is the same for both.

Sorry I don't understand why that's wrong. Apart from where I said "month on month" which should have been "day by day" the sentence is correct is it not?

A yearly account does indeed compound interest day by day but this is only calculated and the balance updated once per year or when you close the account. Yeah?

To put it simply any ISA accounts with the same AER pay the same amount of interest in a given time, regardless of when the interest is paid. Yeah?

Anyway, why I started this thread was post 4 & 6 here:

http://forums.moneysavingexpert.com/showthread.html?t=849803

Before reading this I was absolutely sure that any ISAs with the same AER pay the same, but after reading this I was totally confused. Are post 4 & 6 correct?