Why are interest rates so important?

13th April 2018

Interest rates affect each and every one of us. They are the amount a lender charges a borrower or the reward a saver receives for having a savings account and effectively lending cash to a bank.

Interest Rates

For a saver, the rate of interest that can be earned generally improves the longer you are able to lock your savings away for. So, a five year fixed rate bond that does not allow access within the term will generally pay a better rate of interest than an easy access account for example – though this does of course vary between individual providers.

The difference between gross & AER

The interest rate is generally shown in two different ways, the gross rate and the Annual Equivalent Rate.

Both of these rates are before the deduction of tax. The gross rate shows the actual interest rate that the account is paying today. Whereas the AER is designed to show savers what they will earn if they leave their money in an account for 12 months.

Annual or monthly interest?

If interest is added to an account annually, then the gross rate and the AER should be the same.

Where accounts pay interest on a monthly or quarterly basis, then the rates will differ, usually with a slightly lower gross rate – normally around 0.01 to 0.03% less than the AER.

The reason for this is as interest is added to the account, it will itself earn interest. So, if the monthly interest was taken out each month, the saver would earn the gross rate, but if the interest was allowed to remain in the account and compound, the AER will be slightly higher than the gross rate, as the balance of the account has risen.

As a result, the AER is the best rate to use to compare accounts if you are planning on leaving your money in the account for 12 months or more – and not taking out the interest.

Comparing the AER is also useful when an account has a bonus that is applicable for less than a year and you are planning on leaving your savings in the account after the bonus has ended.

Read this week’s Ask Anna for more details about this type of account and what to watch out for to ensure you don’t get misled by an advertised AER rate.

Does it matter when your interest is paid?

With nearly all savings accounts, the interest is calculated daily – but it is when it is added to the account or paid out to the customer that is important – and, of course, as things are never straightforward, this will vary from one account to another.

Interest can be paid at a number of different times throughout the year and this depends on the type of account you have chosen and the provider.

Some accounts will apply the interest monthly or quarterly, regardless of whether you take the interest away or it’s left to compound.

Others will apply the interest annually, on the anniversary of when the account was opened and funded.

And others will apply the interest annually on a fixed date each year.

But when interest is paid has become more pertinent for savers since the introduction of the Personal Savings Allowance (PSA) in April 2016.

So, for those who are likely to fully use their PSA each year, for basic rate taxpayers this is £1000 and for higher rate taxpayers £500, then when the interest is paid is very important, as the onus is on you to make sure you pay the right amount of tax.

So what difference does this make? Well, when the account you choose applies interest will determine which tax year the interest applies to – and therefore when you may need to pay tax. Let’s look at an example;

On 1st February 2018, Mr B deposited £50,000 into an account earning 2% gross.

Scenario 1

Account A pays interest annually on the anniversary of the account being opened. Therefore, Mr B will see an interest payment of £1,000 gross added to his account on 1st February 2019. This falls into the 2018/19 tax year, as it is paid between 6th April 2018 and 5th April 2019.

Scenario 2

Account B pays interest on 31st March each year. Therefore, Mr B will see a smaller payment of around £166 gross paid into his account on 31st March 2018, which is equivalent of two months interest at 2% and within the 2017/18 tax year.

In both cases the interest accrues daily, so the interest earned is the same– it’s just that with Scenario B, it will not take a year to see the interest – so Mr B should be aware that he may need to pay some tax in 2017/18.

If you were to choose an account where the interest is paid to you on a monthly basis, it can either be paid to a separate bank account or in some cases can be added to the account itself.

How do I pay the tax if I am earning more than my Personal Savings Allowance?

For those who are on the PAYE scheme, HMRC will have some indication of the interest you have earned on your savings and will amend your tax code in order to deduct tax automatically.

However, if your circumstances change – for example you use a large amount of your savings and therefore are not earning as much interest, you might find you are paying more tax in the short term than necessary.

It should all come out in the wash, as the following year HMRC will receive details of the actual amount of interest you earned, so will once again amend your tax code. However, it makes sense to check your tax code as soon as you receive it, to check that the interest they assume you will earn, is similar to what you expect.

Of course, those who do a self-assessment will need to calculate the tax they owe themselves, which makes the dates any interest is applied even more important.

If you have any more questions, give us a call on 0800 011 9705 and one of our savings experts will be happy to help.

You might also like...


Expert advice on the right mortgage deal >>

Whether you're buying a new home, remortgaging to a new deal or buying an investment property, L&C can help and you'll pay no fee for their advice.

Paying tax on your savings

Why pay tax on your savings if you don't need to? >>

How to use available allowances and tax breaks to protect your savings both now and in the new tax year.

Is cash the best investment for me?

Get a free financial plan from Hatch >>

Hatch makes it easy for anyone to plan their finances and achieve their biggest goals.

Contact Us