Understanding how savings interest works helps you compare accounts and make your money work harder. This guide explains AER, compound interest, and how to calculate your returns.
Understanding AER vs Gross Rate
Gross Rate: The simple interest rate before tax. May be paid monthly or annually.
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Savings Interest Formula
Simple Interest
Interest = Principal × Rate × Time
£10,000 × 5% × 1 year = £500
Compound Interest
Final = Principal × (1 + Rate)^Years
£10,000 × (1.05)^3 = £11,576 (£1,576 interest over 3 years)
Best UK Savings Rates January 2025
| Account Type | Typical AER | Top Rate |
|---|---|---|
| Easy access | 4.5-5.0% | ~5.0% |
| Notice (90-day) | 4.8-5.2% | ~5.2% |
| 1-year fixed | 4.5-5.0% | ~5.0% |
| 2-year fixed | 4.3-4.8% | ~4.8% |
| Cash ISA | 4.5-5.0% | ~5.0% |
| Regular saver | 5.0-8.0% | ~8.0% |
Rates change frequently. Always check current offers before opening an account.
Interest Earned Examples
| Amount | Rate | 1 Year | 5 Years |
|---|---|---|---|
| £5,000 | 5% | £250 | £1,381 |
| £10,000 | 5% | £500 | £2,763 |
| £20,000 | 5% | £1,000 | £5,526 |
| £50,000 | 5% | £2,500 | £13,814 |
Personal Savings Allowance
| Tax Band | Allowance | Covers (at 5%) |
|---|---|---|
| Basic rate (20%) | £1,000 | £20,000 savings |
| Higher rate (40%) | £500 | £10,000 savings |
| Additional rate (45%) | £0 | All interest taxed |
Types of Savings Accounts
- Easy access: Withdraw anytime, rates may change
- Notice account: Must give notice (30-120 days) to withdraw
- Fixed rate: Rate guaranteed for term, early access penalties
- Regular saver: Save monthly, often best rates but limits apply
- Cash ISA: Tax-free, £20,000 annual allowance
How Savings Interest Calculations Work: The Methodology
Savings interest calculations involve two core methods: simple interest and compound interest. Understanding the difference is essential for accurately projecting how your money will grow over time.
Simple interest is calculated only on the original deposit (the principal). The formula is: Interest = Principal x Rate x Time. If you deposit £10,000 at 5% for 3 years with simple interest, you earn exactly £500 each year, totalling £1,500 over the full period. Simple interest is rarely used for UK savings accounts but applies to some fixed-term bonds that pay interest annually to a separate account.
Compound interest is calculated on both the principal and any previously earned interest. The formula is: Final Amount = Principal x (1 + Rate/n)^(n x Time), where n is the number of compounding periods per year. Most UK savings accounts compound interest either daily, monthly, or annually. The more frequently interest compounds, the more you earn.
The difference between monthly and annual compounding may seem small, but it adds up over time. For £10,000 at 5% AER over 10 years, monthly compounding yields £16,470, while annual compounding yields £16,289 -- a difference of £181. Over 20 years, this gap widens to nearly £800. This is precisely why AER exists: it standardises the comparison regardless of how often interest is paid.
When calculating interest on regular savings accounts where you deposit a fixed amount monthly, the calculation becomes more complex. Each monthly deposit earns interest for a different duration, so the effective return is approximately half the headline rate. A regular saver offering 8% AER on up to £250 per month will earn roughly £130 in the first year, not £240 as you might expect, because early deposits earn interest for longer than later ones.
UK-Specific Context: The Savings Landscape
The UK savings market is regulated by the Financial Conduct Authority (FCA) and protected by the Financial Services Compensation Scheme (FSCS). The FSCS guarantees up to £85,000 per person, per authorised institution. It is crucial to understand that some banking brands share the same licence -- for example, Halifax and Bank of Scotland are both part of Lloyds Banking Group, so your combined deposits across both are protected up to a single £85,000 limit, not £170,000.
The Personal Savings Allowance (PSA), introduced in April 2016, allows basic rate taxpayers to earn up to £1,000 in savings interest tax-free, while higher rate taxpayers receive a £500 allowance. Additional rate taxpayers (earning over £125,140) receive no allowance at all. At current interest rates of around 5%, a basic rate taxpayer can hold approximately £20,000 in savings before exceeding their PSA.
Cash ISAs remain an important tool for UK savers, particularly those with larger deposits or higher tax rates. The annual ISA allowance for 2025/26 is £20,000, and all interest earned within a Cash ISA is completely tax-free regardless of your income level. Since April 2024, ISA rules have been simplified to allow multiple subscriptions to the same type of ISA within a single tax year, and you can transfer between providers more easily.
The Bank of England base rate significantly influences savings rates across the UK market. When the base rate rises, savings rates typically follow with a delay. However, the relationship is not always proportional. During 2023-2024, despite a base rate above 5%, many high street banks offered easy access rates well below 4%, while challenger banks and building societies often provided more competitive rates. Shopping around and switching accounts regularly can make a meaningful difference to your returns.
NS&I (National Savings and Investments), backed by HM Treasury, offers 100% government-guaranteed savings products including Premium Bonds, Income Bonds, and Direct Saver accounts. Premium Bonds, held by over 22 million UK savers, offer tax-free prizes instead of interest, with a prize fund rate of around 4.0% (though individual returns vary based on luck).
Worked Examples: UK Savings Scenarios
Example 1: Emergency Fund Growth
You deposit £5,000 into an easy access account at 4.75% AER, compounded monthly.
After 1 year: £5,000 x (1 + 0.0475/12)^12 = £5,243.07 (interest earned: £243.07)
After 3 years: £5,000 x (1 + 0.0475/12)^36 = £5,762.29 (total interest: £762.29)
Example 2: Regular Saver
You save £200/month into a regular saver at 7% AER for 12 months.
Total deposited: £2,400. Average balance over the year: approximately £1,300.
Approximate interest earned: £1,300 x 7% = £91
The effective rate on your total deposits is about 3.8%, not the headline 7%.
Example 3: ISA vs Non-ISA for a Higher Rate Taxpayer
£20,000 at 5% AER for 1 year = £1,000 gross interest.
In a Cash ISA: You keep the full £1,000 tax-free.
In a standard account (40% taxpayer with £500 PSA): £500 is tax-free, £500 is taxed at 40% = £200 tax. You keep £800 net.
ISA advantage: £200 per year for a higher rate taxpayer.
Common Mistakes and Tips
Frequently Asked Questions
How often should I switch savings accounts?
Review your savings accounts at least every 12 months, or whenever your bonus rate expires. Many UK savers lose hundreds of pounds annually by leaving money in accounts that have reverted to low standard rates. The switching process is straightforward and most transfers complete within a few working days.
Is my money safe if my bank goes bust?
The FSCS protects up to £85,000 per person per authorised institution. If your bank fails, you should receive your protected money within 7 working days. Joint accounts are protected up to £170,000 (£85,000 per person). For temporary high balances such as house sale proceeds, enhanced protection of up to £1 million is available for 6 months.
Should I choose a fixed rate or easy access account?
It depends on your needs. Easy access accounts suit emergency funds and short-term savings, as you can withdraw anytime. Fixed rate accounts typically offer 0.2-0.5% higher rates but lock your money away, with penalties for early access. If you expect interest rates to fall, locking in a fixed rate can be advantageous. If rates are expected to rise, easy access allows you to switch to better deals.
How do I calculate interest on my savings if I make regular deposits?
For regular monthly deposits, a simplified approach is to use the average balance method. Take your expected average balance over the year (roughly half your total deposits if starting from zero) and multiply by the AER. For more precision, use our savings calculator, which compounds each deposit individually from its date of entry.
Tips to Maximise Returns
- Use your full ISA allowance first
- Consider notice accounts for better rates
- Spread savings to stay within FSCS limit (£85,000)
- Regular savers often have the best rates
- Compare accounts regularly - rates change
- Set up automatic transfers to build savings habit
Frequently Asked Questions
How does the Personal Savings Allowance work in the UK?
What is the difference between a Cash ISA and a regular savings account in the UK?
James Mitchell, ACCA
Chartered Accountant & Former HMRC Advisor
James is a Chartered Certified Accountant (ACCA) specialising in UK personal taxation and financial planning. With over 12 years in practice and a background as a former HMRC compliance officer, he brings authoritative insight to complex tax topics.