My regular savings account pays interest annually, not monthly: Am I missing out on the power of compound interest?
By Ed Magnus For Thisismoney.co.uk
Published: | Updated:
I’m currently saving £200 each month into a Nationwide regular saver paying 4 per cent, which is the maximum it allows me to transfer in each month.
I also have an easy-access account open with Zopa Bank paying me 2.86 per cent which I typically transfer any remaining cash I have leftover each month.
I’ve noticed that with Zopa, the interest is added each month while Nationwide won’t add interest until 12 months after opening the account.
Does this mean that I might actually be losing out by putting money in the higher paying regular saver rather than putting it all in the lower easy-access rate? Via email
Compounding: This means that savings or investments can snowball over time, as you earn a return on top of the gains you have already made
Ed Magnus of This is Money replies: This is a perfectly reasonable question. You are essentially worried that you may be missing out on your interest compounding over time.
Earning returns on top of returns is called compounding. This means that savings or investments can snowball over time as you earn a return on top of the gains you have already made.
For example, if a £1,000 deposit grew by 4 per cent over a year, that would mean its value has increased by £40.
If they make a 4 per cent return on what is now £1,040 in the following year, the value then rises by £41.60 and they end up with £1,081.60. This continues over time, and the longer it does, the greater the effect.
Over a 10 year period, you’ll earn £480.24 in interest. Without compounding that would have been £400.
The fact that a savings account pays interest monthly rather than yearly might make a slight difference due to compounding.
This is why most savings account break down your return into the AER. This stands for Annual Equivalent Rate.
What is the AER on a savings account?
The AER shows what the interest rate would be after a full year, including any compound interest you’d get from any interest paid each month.
The AER therefore makes it easier to compare how much interest you could earn from a savings account if it were open for one year, regardless of the term or type of savings account.
Gross rate is the rate of interest that you would earn at the outset of taking out a savings account. The gross rate may be higher or lower than the AER.
In Zopa’s case the gross rate is in fact 2.82 per cent and the AER is 2.86 per cent.
Someone depositing £200 each month into Zopa’s Smart Saver account will earn £37.51 over a year.
With your Nationwide regular savings account, the rate is 4 per cent gross/AER. There is no monthly compounding to cause the gross rate and AER to differ.
Someone depositing £200 each month into Nationwide’s regular savings deal paying 4 per cent AER will earn £52.64 in interest after one year.
Therefore, you’d be wise to continue paying £200 a month into your Nationwide regular savings account rather than moving what you have already saved up in your Zopa easy-access deal.
We spoke to a spokesperson from the Savings Guru for their expert advice on the matter.
The AER shows what the interest rate would be after a full year, including any compound interest you ‘d get from any interest paid each month.
The Savings Guru replies: Both accounts calculate the interest on a daily basis, so your reader will earn interest on the amount they have in their account regardless of when the interest is actually paid out.
This means that when the interest is paid doesn’t impact how much interest they earn.
However, given this, they will see a big difference in regular savings as they earn 4 per cent on £200 in the first month, 4 per cent on £400 in the second month and so on.
However, if they were to put £2400 into the Zopa account on day one they will earn more interest in the Zopa account compared to what £200 per month will earn at 4 per cent, because of the timing of those monthly payments in.
Someone stashing £2,400 in the Zopa account from day one will end up with £2,469.55 after one year, while someone drip-feeding the £2400 via twelve £200 monthly deposits will end up with £2452.64.
Regular savers are great for people drip-feeding. For example, if you want to put £200 of your salary away each month.
However, easy-access accounts will often be better, even at lower rates, for lump sum funding. If you have the money up front, then often the daily interest on that lump sum will beat drip feeding it via a regular saver, even if the regular saver is a higher rate, because it’s only the last month you earn that higher rate on the whole amount.
Some links in this article may be affiliate links. If you click on them we may earn a small commission. That helps us fund This Is Money, and keep it free to use. We do not write articles to promote products. We do not allow any commercial relationship to affect our editorial independence.