🔔 Ask Anna: Compound interest

Q: I noticed that with one of the accounts in your table, it states that interest cannot be added to the account. What does this mean and what difference does it make?

Anna’s answer:

This is a really interesting question, covering an aspect of savings interest that is often confusing and not always made clear on each account.

Broadly speaking, interest earned on a savings account can be added to the account itself or paid into a separate account. Many accounts allow you to choose between these options but there are others that specify that interest must be paid in a specific way – as is the case with the example that you picked up.

• For more on interest rates and why they are so important, take a look at our recent article here.

The option to have interest paid into an alternative account means that you are able to use that interest and not wait until the end of the account term or annually when the interest is normally added. This can be particularly handy if you wish to choose an account where the rate is fixed for a set period and you have little or no access to the money deposited for the term, but want to get a regular income from your savings. Often this option is used when choosing accounts that pay interest on a monthly basis, but this is not exclusively the case. For example, if you were to pick a five year fixed rate bond, you might simply want to use the interest each year instead of rolling it over.

However, if you are looking to accrue as much interest as possible on your savings and do not need to access that interest over a period of time, the option to pay it into another account is less useful.

All being equal, accounts that allow interest to be added to the account itself will then earn more interest over the same period because of the effect of compounded interest. In other words, you will earn interest on the interest over time and therefore end up with a higher overall return.

Therefore, you need to be careful when selecting your account. If you are looking for the highest return possible and happy to leave your money untouched for the term, then it would be worth considering if the account allows you to add the interest to the account.

For example, Investec’s 2 Year Fixed Term Deposit pays 2.25% gross/AER, but interest needs to be paid into another account – usually your current account.

The total interest received over two years is £1,125 on a balance of £25,000.

You can then compare this to the next best account in our two year fixed rate bond table, from Axis Bank UK*, which is paying a lower rate of 2.24% gross/AER.

The total interest over two years is approximately £1,132 on a balance of £25,000.

Granted, not a huge difference, but it does demonstrate that sometimes the effect of compounding interest can lead to a higher overall return - even when, on the face of it, the interest rate applicable on the account is actually lower. And the longer the term, the more valuable compounded interest can be.

So, it is always important to check all of the key features of any account before proceeding. If you are looking for the highest possible return over the term of an account, then watch out for accounts that insist that interest is paid into another account, as you may be able to get a better return overall elsewhere.

If you need any further help with finding the accounts that are most suitable for your needs, please call us on 0800 011 9705 to speak to one of our expert savings specialists.

*We are occasionally paid by some providers if you click through from our Best Buy Tables and open a savings or current account with them. We will never accept a payment that compromises in any way our independent, whole of market approach to providing information on savings products. For clarity we will indicate those companies who remunerate us with an asterisk (*).

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