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AER - Annual Equivalent Rate
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AER - Annual Equivalent Rate

Readers have recently asked why AER (Annual Equivalent Rates) quoted on vary from the gross interest rates they find on the site.

You may see AERs sometimes described as 'notional' rates used only to compare accounts. We think this understates their importance highlighting the difference from gross rates.

So what do the published interest rates mean?

On you will see that we rank accounts by gross interest rate. This is the annual interest rate you should receive for your savings on the day you invest, assuming that the same interest rate was maintained for a full year, and that your interest was paid exactly a year later.

In reality the relationship between the headline rate and bank and building society rates is of course more complicated:

* There may be a special offer - a higher interest rate being paid for an introductory period of maybe 3 or 6 months to attract savers and in the hope that you will forget, and leave your deposit with them longer at the lower ongoing rate

* You may choose to receive, or the bank may choose to pay interest more often than once a year; perhaps monthly, quarterly or even daily in the case of the Money Market Accounts covered by a seperate Briefing. That is why you will typically find that, where you are given the option to receive interest monthly, the gross interest rate for monthly payment of interest is normally lower than for annual payment whilst the AER is the same.

* Most frequent payment of interest may sound attractive. However if, for example, you had 100 deposited, daily interest payment would mean getting around 1p a day in interest; a nuisance for you and impractical for the bank. Accordingly the bank may opt to compound, or add interest to, your account daily but only pay out the interest monthly, say. They could therefore add the 1p to your account each day thus increasing the amount on which you earn interest the next, but pay out the accrued interest at less frequent intervals

* Your bank of building society may pay interest once a year on a fixed date which might not be the anniversary of your investment. Receiving your interest earlier is a benefit since you could choose to add this interest to your investment to increase the amount of interest you receive later on

How can you therefore compare the rates you are being offered from such a variety of accounts?

The answer is by comparing the AER or Annual Equivalent Rate. Instead of the instantaneous gross rate described above, the AER assumes in each case that your investment carried on for a full year.

One should be aware of a number of anomalies with AER

* AER assumes that income received during the year would be reinvested, but in the case of most savers tax would be deducted before the interest could be reinvested, thus reducing the effective AER. In this respect a net AER, rarely available, would be more accurate.

* Where an investment is by its nature short term, assumptions need to be made about what would happen to the funds after redemption. For example how should an AER be calculated for a 6 month bond returning principal and interest at maturity?

Why do we not use AER as the primary rate quoted in the tables on

If you were to keep your money indefinitely on an account the AER is indeed a more reliable measure. However we assume that our readers are likely to be more active, wishing to take advantage of offers from banks and building societies. We assume that you will move your money about to take advantage of these offers which are best highlighted by the quoted gross rates.

Finally. Should you want to calculate the AER of an investment it is given by

AER%=100 x {(1 + r/100)n - 1}

where n payments are made each year and r is the percentage interest rate for the period



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