Finance⏱ 5 min read
How to Calculate Interest on Your Savings Account
AER, gross rate, and net rate are all different. Here is how savings interest is actually calculated, what AER means, and how to compare accounts that compound at different frequencies.
Banks quote savings rates in several different ways, and comparing them directly can mislead you. Understanding the calculation behind AER makes comparison straightforward.
Simple vs Compound Interest
Simple interest (rare in savings accounts):
Interest = Principal x Rate x Time
£10,000 at 5% for 3 years = £10,000 x 0.05 x 3 = £1,500
Compound interest (standard for savings):
Final amount = P x (1 + r/n)^(nt)
P = principal, r = annual rate, n = compounds per year, t = years
£10,000 at 5% compounded monthly for 3 years:
= 10,000 x (1 + 0.05/12)^(12x3)
= 10,000 x (1.004167)^36
= 10,000 x 1.16147
= £11,614.70
Total interest: £1,614.70 (vs £1,500 simple -- 7.6% more)
What AER Actually Means
AER (Annual Equivalent Rate) standardises rates to annual compounding.
It allows fair comparison between accounts with different compound frequencies.
AER = (1 + gross rate / n)^n - 1
Account A: 5.0% gross, compounded monthly (n=12)
AER = (1 + 0.05/12)^12 - 1 = (1.004167)^12 - 1 = 0.05116 = 5.116% AER
Account B: 5.05% gross, compounded annually (n=1)
AER = (1 + 0.0505/1)^1 - 1 = 5.05% AER
Account A has higher AER despite lower gross rate --
because monthly compounding earns interest on interest 11 times.
When comparing savings accounts: always compare AER, not gross rate.
Monthly Interest Calculation
Monthly interest = Balance x (Annual rate / 12)
£25,000 at 4.8% AER (monthly compounding):
Monthly rate = 4.8% / 12 = 0.4%
Month 1 interest = £25,000 x 0.004 = £100
Month 2 balance = £25,100
Month 2 interest = £25,100 x 0.004 = £100.40
...
After 12 months:
Balance = £25,000 x (1.004)^12 = £25,000 x 1.04907 = £26,226.80
Interest earned: £1,226.80 (vs £1,200 at simple rate -- difference is compounding)
Tax on Savings Interest
UK Personal Savings Allowance (2024/25):
Basic rate taxpayer: £1,000/year tax-free interest
Higher rate taxpayer: £500/year tax-free interest
Additional rate taxpayer: £0 (no allowance)
Interest above the allowance is taxed at your marginal rate.
Basic rate: 20% | Higher rate: 40%
At 4.8% AER: how much savings before you exceed the PSA?
Basic rate taxpayer: £1,000 / 0.048 = £20,833
Higher rate taxpayer: £500 / 0.048 = £10,417
If you have more than these amounts earning interest:
Consider using Cash ISA (always tax-free) for the excess
Cash ISA vs easy access: compare the after-tax equivalent rate
If ISA pays 4.3% and easy access pays 4.8%:
After tax (basic rate above PSA): 4.8% x 0.80 = 3.84% -- ISA wins