How is interest worked out?

By THIS IS MONEY
Updated:

 

Can you explain how the interest is worked out on say, £1000 in an ordinary bank account? If the money was not touched and the interest was 3% is it 3% of £1000 for the month (£30), or is it worked out quarterly? SD, London.

Brian Capon, of the British Bankers Association, says: Under banking rules, your bank must tell you exactly how your interest is worked out if you ask. But here's a basic guide. The interest paid on an account is usually expressed as an annual percentage (eg 3% per annum gross). This is called the contractual rate. This means that over a year the amount saved will earn 3% interest (eg a deposit of £1000 left in the account for the whole year will earn £30). But to find out what you actually get you need to look at how often interest is paid - which can vary between accounts. If interest is credited to the account more frequently than once a year, the total amount paid in the year will actually be slightly more than £30. This is because each time interest is added to the account, the next period's interest will be calculated on the increased balance. For personal deposits, tax will be deducted from the interest paid at 20% unless the customer is a non-taxpayer and provides the bank with a declaration to that effect. For business customers, interest will usually be paid gross. The more frequently interest is credited to the account, the higher the actual amount of interest paid. For instance:

• Balance £1,000 Interest credited to account monthly: £1000 x 3% = £30 divided by 12 = £2.50 for month one. The £2.50 interest will be added to the £1,000, so that for the second month the calculation will be based on the higher amount of £1,002.50, ie, £1,002.50 x 3% = £30.07 divided by 12 = £2.51. The £2.51 will in turn be added to the £1,002.50 and the next month's calculation will be based on £1,005.01 and so on throughout the year. The total amount of interest paid will therefore be slightly more than £30 which will mean that the true rate of interest paid during the year will actually be slightly than 3%. This rate is the Annual Equivalent Rate (AER).

• Balance £1,000 Interest credited to account half yearly: £1,000 x 3% = £30 divided by 2 = £15.00 for the first 6 months. The £15 interest will be added to the £1,000, so that for the second half of the year the interest will be calculated on £1,015.00: £1015.00 x 3% = £30.45 divided by 2 = £15.23.

The total amount of interest paid during the year will therefore be £30.23. The true annual rate of interest (AER) will again be slightly higher than 3%

An advertised rate should state whether it represents the gross or net rate. The advertisement should also quote the AER. This reflects the true annual rate of interest regardless of whether interest is paid monthly, quarterly, half yearly, annually or any other period. It must be given at least equal prominence as the contractual rate.

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