What are interest rates and how do they work?

Learn how interest on savings works – from how it’s calculated to the power of compound interest and what AER means.

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Interest is the reward you get for holding your money in a savings account. You earn a percentage of interest either monthly or annually. This boosts your balance and can help you reach your savings goals.

Understanding how interest works makes it easier to manage your money. In this guide, we’ll explain:

  • What interest is
  • How it’s calculated
  • The difference between simple and compound interest
  • What AER means.

What are interest rates?

An interest rate is the percentage a bank or building society pays you for keeping your money in a savings account. It reflects how much your savings will grow over time.

Interest rates can vary depending on the type of savings account you choose. Some offer fixed rates for a set term, while others have variable rates that can go up or down.

How does interest work on a savings account?

Earning interest in a savings account is like your bank paying you to keep your money deposited with them.

Your savings account’s interest rate affects how much interest you earn. Interest rates are shown as a percentage. For example, a 3% interest rate means you’d earn £30 a year for every £1,000 saved. Higher interest rates mean more money is paid into your account. 

How is savings interest calculated?

The simplest way to calculate how much interest you earn is by multiplying your account balance, interest rate and how long your money will be in the account. 

You can use this simple formula: Interest = P x R x T

  • P = Principal amount (account balance)
  • R = Interest rate
  • T = Time (in years)

For example, if your savings account has a balance of £5,000 and a 4% interest rate per year, you’ll earn £200 interest in a year. This takes your balance to £5,200. 

You can work this out using the formula (4% interest is expressed as 0.04):

Interest (£200) = account balance (£5,000) x interest rate (0.04) x time (1)

What does base rate mean for savings accounts? 

Interest rates are influenced by the base rate, which is set by the Bank of England (BoE). When the base rate rises, there’s likely to be a knock-on effect, with bank savings interest rates also rising. 

Fixed-rate savings accounts are an exception. Their interest rates are set in stone for the length of their term and are not affected by changes to the base rate. For example, if you set up a 2-year fixed-rate savings account with a 4% interest rate, that’s the rate you’ll get for the whole period, even if the base rate rises.

What does AER stand for?

AER stands for Annual Equivalent Rate. You can use it to work out how much interest you earn per year in savings and investment accounts. 

It’s always shown as a percentage. The higher the percentage AER an account offers, the more interest you can expect to earn. You can use AER when comparing savings options.

How is AER calculated?

Many factors influence how AER is calculated. These include gross interest earned in a year, compound interest and how often interest is added (monthly, biannually or annually). 

AER is shown as a percentage, for example, 3%. If you put £1,000 into a savings account with 3% AER and leave it for a year, you’d earn £30 in interest.

If you deposit £10,000 into an account with 5% AER and leave it for three years, here’s how your savings could grow:

Representative example

Year Annual interest earned Total interest earned Account balance

1

£500

£500

£10,500

2

£525

£1,025

£11,025

3

£551.25

£1,576.25

£11,576.25

You’ll notice that the amount of interest you earn each year goes up. This is known as compound interest, which we explain later in this guide.

What’s the difference between AER and gross interest?

The main difference is that AER includes compound interest, while gross interest does not.

This means AER gives a more accurate picture of how much you could earn over time, especially if interest is added more than once a year. Gross interest only shows the basic rate, without factoring in how often interest is paid or compounded.

Do you have to pay tax on savings interest?

Most people in the UK can earn some interest on their savings without paying tax, thanks to the Personal Savings Allowance (PSA).

How much you can earn tax-free depends on your income tax band:

  • Basic rate taxpayers (income between £12,570 and £50,270). Up to £1,000 of interest is tax-free.
  • Higher rate taxpayers (income between £50,270 and £125,140). Up to £500 tax-free.
  • Additional rate taxpayers (income over £125,140). No tax-free savings allowance.

If you earn more interest than your allowance, the extra amount is taxed at your usual income tax rate.

What about ISAs?

You also get an ISA allowance each tax year. This lets you save up to £20,000 in ISAs and all returns are completely tax-free. This includes Cash ISAs and Stocks and Shares ISAs.

Unlike regular savings accounts, interest earned in an ISA doesn’t count towards your PSA.

Do banks notify HMRC of savings interest?

Yes, banks and building societies report all the interest you earn to HMRC at the end of each tax year. They’re required to do this by law under the Finance Act 2011.

HMRC uses this information to help fill in your tax details. They can update your tax code if you're on PAYE or check your self-assessment tax return if you file one.

What is simple interest?

Simple interest is money you earn just from your original deposit. It doesn’t change, as long as the interest rate stays the same.

Example: If you put £10,000 into an account with a 5% yearly interest rate for two years, you’ll earn £1,000 in total. That’s £500 each year.

What is compound interest?

Compound interest works a bit differently. It's the interest you earn on your initial deposit plus the interest already added to your balance.

Example: If you deposit £10,000 at a 5% yearly interest rate for two years, you’ll earn £1,025. That’s £500 in the first year. In the second year, you earn 5% on £10,500 – which is £525.

How often is interest compounded?

Interest can be compounded at different times. It depends on the type of savings account and the provider. Some providers do things differently, but the most common options are:

  • Monthly. Interest is worked out and added once a month.
  • Quarterly. Interest is worked out and added every three months.
  • Annually. Interest is worked out and added once a year.

Why compound interest is better in the long term

Compound interest can help your savings grow faster. That’s because you earn interest on your original deposit and on the interest you’ve already earned.

But if you’re borrowing money, simple interest might be better. You’d pay less overall, since you’re only charged interest on the original amount.

How does inflation affect your savings interest?

Inflation means prices go up over time – for things like food, clothes and services. If inflation rises faster than the interest rate on your savings, your money loses value. You’ll still have more money in your account, but it won’t buy as much.

Example: You save £10,000 in an account with a 2% interest rate. After one year, you’ll have £10,200. But if inflation is 3%, something that cost £10,000 at the start of the year will cost £10,300 by the end. So even though you earned interest, your money won’t stretch as far.

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