What is AER?

Personal finance is full of acronyms. You’ve probably come across many of them when looking at the variety of savings accounts on offer. One particularly important one is AER. This stands for ‘Annual Equivalent Rate’.

But what exactly does it mean, and why should you care? In this article, we’ll explain AER, help you understand why it’s a fantastic tool to know about when choosing a savings accounts, as well as cover how AER affects your savings.

What is AER? 

AER is the percentage of interest you’ll earn on your savings over a year, including compounding. In simple terms, AER helps you understand how much your money could grow in a year. Understanding AER allows you to compare different savings accounts and make a more informed decision about where to deposit your hard-earned money. 

Together with AER, compounding is a related and powerful concept. It is also closely linked to AER. When you earn interest on your savings, that interest is added to your balance. As a result, you start earning interest on the new total.

A good analogy to think about is of a snowball rolling downhill. At first, the rolling snowball is small, but as it picks up more snow, it gets bigger and bigger. The same thing happens with your savings — over time, the interest you earn also starts earning interest. This can make a big difference in the long run with how much you can save. Think of this as a win-win for your savings.  

Why is AER Important? 

When browsing the different savings account available, AER plays an important role because it: 

1. Makes Comparing Savings Accounts Easier – Banks will advertise various interest rates for their savings accounts, but looking at the AER gives an initial way to compare them. This helps you evaluate the various savings accounts available. In turn, you can make a more informed decision of which savings account to open. Think of AER as a way of levelling the playing field in being able to compare the variety of options in front of you. However, don’t use AER as the sole measure by which you compare savings accounts!

2. AER Considers Compounding – You’ve probably noticed that different savings accounts come with different features. For example, some account pay interest monthly, while others pay it annually. Because AER factors in compounding, so you’re not left guessing which account will grow your savings faster, regardless of how often interest is paid in. 

How to Use AER When Choosing a Savings Account 

While AER is an important tool, it’s not the only factor to consider. Keep the following points in mind when choosing a savings account: 

• Account fees – AER does not include any bank fees or charges, which could reduce your total earnings. Be sure to understand these before selecting an account. 

• Account restrictions – Savings accounts with higher AERs often come with more restrictive conditions, such as limited withdrawals or fixed deposit periods. If you need easy access to your money, ensure you understand the restrictions which will come with that savings account. Sometimes these restrictions will fit your savings goals, sometimes they will not.  

• Taxes – AER does not consider your tax liability on the interest you will accrue. Have at look at HMRC’s webpages for advice on navigating any potential tax liability generated to savings interest earned. HMRC also have a handy tax calculator where you can estimate your tax liability based on the earned interest from a savings account. 

Example: How AER Affects Your Savings

Ben has been working at first job after university. He has managed to save £1,000 over the course of a few months. He wants to put this money into a savings account but isn’t sure which one to pick. After looking at different options, he finds a bank advertising a savings account with 5% AER, with interest paid monthly.

It’s also an easy-access savings account, which is important to Ben, because he anticipates wanting to buy a second-hand car in the coming months. After comparing this account to the potential alternatives, this one sounds like the best fit for him, so he decides to open this account. 

If Ben doesn’t withdraw or add any additional money into this account, his savings will grow as follows: 

• Monthly Interest Rate: 5% AER is an annual rate; so, the monthly interest rate Ben will earn is 5% ÷ 12 (months) = 0.416% per month. 

• Interest Earned After Month 1: After the first month, Ben will earn £4.17 in interest, bringing his balance to £1,004.17. 

• Compounding Effect: From this point onward, the interest is calculated on the new total, bringing the subsequent month’s interest accrued to £4.18. This means that his new balance after the second month will be £1,008.35. 

• After 12 Months: If he doesn’t withdraw anything, his balance will grow to £1,051.16. 

• Deposits or Withdrawals: If Ben adds more savings to his account, his total savings will grow faster. Likewise, if he withdraws money, his savings will grow more slowly. 

Final Thoughts 

Understanding AER is a simple yet powerful way to make smarter financial decisions. However, AER shouldn’t be the only factor when choosing a savings account. Consider other features like account flexibility, account restrictions, and potential tax implications (which will be based on your personal circumstances). By making a more informed choice, you can grow your money with greater confidence.