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Understanding Interest

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All savers want to earn as much interest as possible, but jargon can make it difficult to understand exactly how your returns are calculated.

Here, we look at how interest works, as well as the different ways it can be expressed.

Interest: the basics

When you pay money into a savings account, you will be paid interest on this sum. But the amount of interest you earn on your savings will depend on several different factors. These include the kind of savings account your have chosen as well as the Bank of England base rate, which is the ‘official’ interest rate for the UK.

When the base rate is low, so are returns from savings account, but when the base rate is high, savers can expect to earn more competitive rates of interest. Some accounts will pay you a fixed rate of interest, which won’t change during the term of the account, while others pay variable rates, so the amount of interest you earn could go up or down at any time.

How is interest shown?

Savings providers express the amount of interest you will earn in different ways, so it’s important to get to grips with them to ensure you are comparing like-with-like.

This tax year (2016/17) each individual has a personal allowance of £11,000.

Gross

The gross interest rate is the amount of interest you will earn before income tax is deducted. Savings providers used to deduct tax at 20% automatically from savings accounts, but following the introduction of the new Personal Savings Allowance in April 2016, all interest is now paid gross. The PSA means basic-rate taxpayers can earn £1,000 of savings interest without the taxman taking a slice. Higher-rate taxpayers can earn £500.

AER

The Annual Equivalent Rate (AER) is the official rate for savings and refers to the amount of interest that is added to your account each year. It also factors in compound interest.

Compound interest is where you earn interest on the interest you have earned, as well as on your initial investment.

As a result, when you look at the monthly interest paid by an account, the AER shown will be higher than the gross rate, but where interest is paid annually, the gross rate and the AER will be the same.

Like the gross rate, the AER shows how much interest you will earn before tax is deducted.

When will I be paid interest?

Most accounts pay interest annually, but some also offer the option for savers to receive interest monthly instead, which can be useful for anyone looking to supplement their income.

If accounts display a monthly and annual rate of interest, you will probably notice that the monthly rate is marginally lower than the annual rate. This is because if you don’t opt to take interest monthly, that interest stays in your account, and earns interest itself.

How will I be taxed?

This tax year (2016/17) each individual has a personal allowance of £11,000, although those aged 75 or over have a slightly higher personal allowance of £11,660.

Because of the Personal Savings Allowance, you can earn up to £1,000 in interest before you have to pay any tax. You’re a basic rate taxpayer in the 2016-17 tax year if your income is less than £43,000).

If you’re a higher rate taxpayer, paying tax at the 40% rate on an income between £43,001 and £150,000, you’re can earn up to £500 interest a year before paying tax. 

If you’re an additional taxpayer earning £150,001 or more, you won’t get an allowance at all.

Any tax you owe on your savings will usually be collected through the Pay As You Earn (PAYE) system, although you may need to declare it on your self-assessment system. If in doubt, check with HMRC.

There is no tax to pay on savings held in an ISA (Individual Savings Account) and in the current 2016/17 tax year you can save up to £15,240 in an ISA – all in cash if you want to.

Base rate changes 

You can work out how your mortgage repayments will be affected by changes in the base rate by using our helpful base rate calculator.

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