The Three Interest Rate Terms Explained
Before understanding how interest is calculated, you need to know which rate actually tells you what you'll earn.
For savings: always compare using AER. For borrowing: always compare using APR. The gross rate and the AER look similar but aren't identical — AER is always the correct figure for comparing savings accounts because it accounts for compounding. A 4.9% gross rate compounding monthly equals 5.00% AER.
How Savings Interest Is Actually Calculated
Most UK savings accounts calculate interest daily and pay it monthly or annually. The daily calculation is simple:
Daily interest = (£10,000 × 0.05) ÷ 365 = £1.37 per day
Monthly (30 days) = £1.37 × 30 = £41.10
Annual = £1.37 × 365 = £500.00
Because interest compounds — each month's interest is added to your balance and then earns interest itself — your actual annual total is slightly higher than the simple multiplication of daily rate × 365, especially on larger balances or over longer periods. This compounding effect is exactly what AER already accounts for, which is why AER is the authoritative comparison figure.
Monthly vs Annual Compounding — Does It Matter?
Some accounts credit interest monthly, others annually. Monthly compounding produces slightly higher returns because each month's interest immediately joins the balance and starts earning more interest. The difference is small but real:
| £10,000 at 5% AER | After 1 Year | After 3 Years | After 5 Years |
|---|---|---|---|
| Monthly compounding | £10,511.62 | £11,614.72 | £12,833.59 |
| Annual compounding | £10,500.00 | £11,576.25 | £12,762.82 |
| Difference | £11.62 | £38.47 | £70.77 |
Difference grows with time and balance size. Both figures assume 5.00% AER — the AER already standardises for compounding frequency.
APY vs AER — US Readers
In the United States, the equivalent of AER is called APY (Annual Percentage Yield). They measure the same thing — the true annual return accounting for compounding. When comparing US savings accounts, always use APY. The APR figure on savings products is lower than APY and is the less useful comparison figure. A 4.88% APR compounding monthly = 5.00% APY — the APY is what you earn.
Why Do Banks Pay Different Rates on the Same Balance?
You might notice that some banks pay the same AER on a £1,000 balance as on a £100,000 balance, while others have tiered structures where the rate increases with your balance. Neither is necessarily better — it depends on your balance size. Three main models exist:
- Flat rate: Same AER on all balances. Common at online banks. Simple and transparent.
- Tiered rate: Higher rate as your balance crosses thresholds. Always check whether the higher rate applies to the full balance or only to the portion above the threshold.
- Bonus rate: A headline rate that includes a temporary bonus (e.g. +0.50% for the first 12 months). After the bonus expires, the rate drops. Read the "underlying rate" or "standard rate" to know what you'll earn long-term.
How Banks Use Your Money to Pay You Interest
Banks pay interest on deposits because they use those deposits to make money elsewhere — primarily through lending. The model is straightforward:
- You deposit £10,000 in a savings account at 5% AER. The bank pays you £500/year.
- The bank lends a portion of that £10,000 to mortgage borrowers at 6.5% or to businesses at 7–9%.
- The margin between what the bank pays you (5%) and what it charges borrowers (7%+) is the bank's profit — the "net interest margin."
This is why the Bank of England base rate matters so much for savings. When the BoE raises its rate, banks can charge more for loans, so they can afford to pay more for the deposits that fund those loans. When the BoE cuts, lending rates fall and so does the competition for deposits — savings rates follow downward.