How Savings Account Interest Works: AER, Gross Rate and Compounding
When you deposit money in a savings account, the bank pays you interest as a reward for keeping your money there. The rate is expressed as a percentage of your balance, and the frequency of compounding — how often interest is calculated and added to your balance — determines how quickly your money grows.
AER (Annual Equivalent Rate) is the standardised rate used to compare savings accounts. It shows what you would earn over a full year, including the effect of compounding. For example, if a bank pays 5% gross monthly, the AER will be slightly above 5% because each month's interest itself earns interest in subsequent months.
Gross rate is the actual interest rate paid before tax and before compounding adjustments. When comparing accounts, always use the AER — it is the fairest comparison figure.
Daily, Monthly and Annual Compounding
Daily compounding means interest is calculated on your balance every day, then added. This gives the highest returns because your interest earns interest the very next day. Monthly compounding is the most common: interest is calculated and credited once a month. Annual compounding calculates interest once per year — the least frequent and slowest-growing method for the same headline rate.
The difference in practice is small at typical savings rates. On £10,000 at 5% over 1 year: annual compounding gives £500; monthly gives £511.62; daily gives £512.67. The gap widens over longer terms and higher balances.
Personal Savings Allowance (PSA) 2025/26
The Personal Savings Allowance allows UK taxpayers to earn a certain amount of savings interest tax-free each year outside of an ISA. For 2025/26:
- Basic rate taxpayers (income up to £50,270): £1,000 tax-free interest per year
- Higher rate taxpayers (income £50,271 to £125,140): £500 tax-free interest per year
- Additional rate taxpayers (income over £125,140): No PSA — all savings interest is taxable
Interest earned above your PSA is taxed at your marginal rate: 20% for basic rate, 40% for higher rate, 45% for additional rate. Banks no longer deduct tax at source — HMRC will adjust your PAYE tax code or you must declare it via self assessment if you earn over your PSA.
Interest in a Cash ISA is always tax-free and does not count towards your PSA. This makes ISAs especially valuable for higher earners with large savings pots.
Best Savings Accounts UK 2025: Where to Put Your Money
Chase Bank UK (operated by JP Morgan) has consistently offered market-leading easy access rates since launching in the UK. As of February 2026, their easy access saver pays around 5.1% AER. The app is slick and funds are easily accessible. FSCS protected.
Chip is a savings app that aggregates accounts from multiple banking partners. Its AutoSave feature rounds up transactions and moves spare cash into savings automatically. Rates have been highly competitive in the easy access space.
Plum and Trading 212 have disrupted the Cash ISA market with rates of 4.8% AER easy access. Both are technology-led platforms, FSCS-protected via partner banks.
Atom Bank and Shawbrook have led the fixed-rate bond market, offering 1-year bonds at approximately 5.0% AER. These accounts lock your money away for the full term but offer certainty of return.
Marcus by Goldman Sachs remains a strong easy access option, known for reliability and competitive rates for established savers.
Nationwide Building Society offers both easy access and fixed rate products, with the Triple Access Saver often competitive for regular savers. Nationwide is a mutual, meaning profits return to members rather than shareholders.
Fixed Term Bonds vs Easy Access: When to Lock Your Money Away
A fixed-rate savings bond locks your money for a set period (typically 1, 2 or 3 years) in exchange for a guaranteed rate. If the Bank of England cuts rates during your fixed term, you still earn the rate you locked in. The risk is that if rates rise, you miss out unless you break the bond — which usually incurs a penalty equivalent to 90–180 days' interest.
An easy access account lets you withdraw at any time without penalty. Rates can change at any time — when the Bank of England cuts the base rate, easy access rates usually fall quickly. However, you retain full flexibility.
The right choice depends on your circumstances: if you have an emergency fund covered elsewhere and will not need the money for a year or more, a fixed-rate bond can earn more. If you might need the money, easy access is safer.
ISA Allowance 2025/26: £20,000 Annual Limit
The annual ISA allowance for 2025/26 remains at £20,000 per person. This can be split across different ISA types in the same tax year (Cash ISA, Stocks and Shares ISA, Innovative Finance ISA), as long as the total does not exceed £20,000. Once invested in an ISA, money grows and can be withdrawn tax-free forever — with no limit on the total ISA pot size.
The Lifetime ISA (LISA) has a separate annual allowance of £4,000 (included within the £20,000 overall limit). The government adds a 25% bonus on contributions (up to £1,000/year bonus). LISAs can only be used to buy a first home or access in retirement from age 60. Withdrawing for any other reason incurs a 25% penalty that recoups the government bonus and some of your own savings.
FSCS Protection: Is Your Money Safe?
The Financial Services Compensation Scheme (FSCS) protects your savings up to £85,000 per person per authorised institution (£170,000 for joint accounts). If your bank, building society or credit union fails, FSCS guarantees payment of up to £85,000 within 7 business days.
Critically, the £85,000 limit is per banking licence, not per brand. Some banks share a banking licence: Halifax, Bank of Scotland and Intelligent Finance are all part of Lloyds Banking Group and share a single FSCS limit. If you have more than £85,000 to save, spread it across institutions with separate banking licences.
NS&I (National Savings and Investments) is backed by the UK government directly — there is no upper limit on the protection offered, making it the safest place to hold any amount of savings. Premium Bonds (up to £50,000 per person) and NS&I savings accounts carry full government backing.
Premium Bonds: Worth It in 2025?
Premium Bonds from NS&I offer a prize fund rate equivalent to 4.40% in 2026. Instead of guaranteed interest, your bonds are entered into a monthly prize draw. Tax-free prizes range from £25 to £1 million. You can hold up to £50,000 in Premium Bonds.
The 4.40% prize rate is a statistical average — some savers will win more, most will win less. If you hold a large amount (£30,000+), the law of large numbers means you are likely to receive close to the headline rate. For smaller amounts, your actual return can be significantly below the prize fund rate due to variance. Many financial commentators recommend Premium Bonds only for those who have already maximised their ISA allowance and are looking for tax-free returns on larger sums.
Should You Overpay Your Mortgage or Save?
With savings rates at 5%+ and many fixed rate mortgages at 4–5%, this is a genuine dilemma. The mathematical answer: if your mortgage rate is higher than your after-tax savings rate, overpay the mortgage. If your savings rate (after tax) is higher, save.
For basic rate taxpayers with a £1,000 PSA, saving at 5.1% in an easy access account before the PSA is exhausted is better than overpaying a 4.2% mortgage. For higher rate taxpayers with a £500 PSA, the tax on savings interest makes the comparison tighter — a Cash ISA at 4.8% AER tax-free competes closely with overpaying a 4.5% mortgage.
Inflation-Adjusted Real Returns
UK CPI inflation stood at approximately 2.5% in early 2026. With easy access rates at 5.1%, the real return (after inflation) is approximately 2.5–2.6% — a genuine positive real return for the first time in several years. This represents a healthy environment for savers compared to the 2021–2022 period when savings rates of 0.1% and inflation of 10%+ meant money lost purchasing power at an alarming rate.
Always consider inflation when planning long-term savings. Over 10 years at 2.5% annual inflation, £10,000 today has the purchasing power of only £7,812. To maintain real-terms wealth, your savings must outpace inflation after tax — currently achievable with today's best rates, but this depends on how inflation and interest rates evolve.