Gross interest and AER
When comparing savings accounts, you'll frequently see terms like gross interest and Annual Equivalent Rate (AER).
In this guide
While both refer to the interest you earn, they serve different purposes. Gross interest is the simple rate applied before tax and without considering compounding. AER, on the other hand, reflects the true annual return by factoring in how often interest is compounded.
Understanding the difference between these two rates is essential for choosing the best savings account. AER provides a more accurate comparison, helping you evaluate accounts with different compounding structures.
Key terms used in this guide6 terms
Definition
Gross interest
The interest rate before tax, without accounting for the effect of compounding.
Gross interest
Gross interest refers to the simple interest rate applied to your savings, without taking into account any compounding. It's the rate of interest before tax, but more crucially, it doesn't consider how frequently the interest is added to the balance over time.
Unlike simple interest, which is only calculated on the initial principal, compound interest helps your money grow faster. The more frequently interest is compounded, the greater the overall effect, making compound interest a crucial factor in long-term investments and savings.
Formula for gross interest
Gross (or simple) interest is calculated solely on the principal, or the original investment or loan amount. Unlike compound interest, it does not take into account the accumulated interest over time. As a result, simple interest leads to slower growth because the interest is earned only on the principal, not on previously earned interest.
The formula for calculating simple interest is:
Where:
- i
- Gross interest, also known as simple interest
- P
- Principal (initial investment or loan amount)
- r
- Annual interest rate (as a decimal)
- t
- Time (in years)
Example: If you invest £1,000 at an interest rate of 5% for 5 years, the simple interest would be £250 (£1,000 × 0.05 × 5). This would bring the total amount after 5 years to £1,250.
Annual Equivalent Rate (AER)
AER is designed to give a more accurate reflection of how much interest you'll earn on your savings over a year by factoring in the effect of compounding. It assumes that interest is being paid and added back to the balance periodically, and this added interest will itself start earning more interest.
How AER captures growth
AER includes the effect of earning interest on interest during the year. It assumes each interest payment stays in the account and continues to earn interest.Interest growth
Over time, the interest you earn starts to grow by itself, helping your savings grow faster.
Reinvestment of earnings
Reinvesting your earnings leads to more growth as the reinvested interest starts earning interest itself.
Why AER helps comparisons
AER expresses the return from different payment and compounding schedules as one annual rate. This lets you compare savings accounts on a consistent basis.True annual return
AER reflects the actual return on your savings over a year, after considering compounding, and is often higher than the gross rate for accounts that compound interest.
Standardised measure
AER is a useful comparison tool when evaluating accounts with different interest payment frequencies or structures, as it provides a clearer idea of overall earnings.
Formula for Annual Equivalent Rate (AER)
Compound interest is calculated using a formula that accounts for the initial principal, the interest rate, and the frequency with which the interest is compounded. This formula helps you determine how much an investment or loan will grow over time with compound interest.
The formula for calculating compound interest is:
Where:
- A
- Final amount (principal + interest)
- P
- Initial, or principal amount
- r
- Annual interest rate
- n
- Number of times interest is compounded per year
- t
- Time, in years
Example: If your savings account pays a 5% gross interest rate but compounds daily, the AER may be around 5.13%, reflecting the extra interest you earn due to compounding.
Comparison table
Below is a table comparing the key differences between Gross Interest and Annual Equivalent Rate, AER.
Compare the rates
- Compounding
- Does not consider the impact of compounding periods.
- Formula
- I = P × r.
- Purpose
- Shows the nominal interest rate before compounding.
- Use case
- Useful for knowing the base rate offered by an account.
Same gross rate, different AER
The same gross rate gives a slightly different AER depending on how often interest is added. More frequent compounding earns a little more, so AER lets you compare accounts that pay at different intervals.
| Interest added | Times a year | AER | Interest on £10,000 | Difference |
|---|---|---|---|---|
| Annually | 1 | 4.25% | £425.00 | — |
| Half-yearly | 2 | 4.30% | £429.52 | +£4.52 |
| Quarterly | 4 | 4.32% | £431.82 | +£6.82 |
| Monthly | 12 | 4.33% | £433.38 | +£8.38 |
| DailyProviders may calculate daily interest using 365 days, 360 days or 366 days in a leap year. Check the account terms because the day-count convention can slightly change the amount earned. | 365 | 4.34% | £434.13 | +£9.13 |
Gross and AER calculator
Try our calculator to explore how compounding frequency impacts the AER. For more information on compound interest, read our compound interest guide.
Inputs
Enter the gross rate and select the compounding frequency.
Rate conversion
The bottom line
Use AER to compare savings accounts on a like-for-like basis. It turns different interest payment and compounding schedules into one annual figure, making it easier to see which account offers the stronger return.
AER gives you the fuller picture. It includes the effect of compounding, so it reflects what the account would pay over a year if the interest stays in the account. Gross interest still helps you understand the underlying rate, but AER is the better figure for comparing accounts that pay interest at different frequencies.
