How does interest work?

Interest is the reward you receive 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.

It's easier to manage your finances when you understand how interest works. In this guide we explain interest, compound interest, AER how interest is calculated and much more. 

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. Higher interest rates mean more money is paid into your account. 

Interest rates are influenced by the base rate, which is set by the Bank of England (BoE). When the BoE 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 BoE 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 BoE base rate rises. 

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

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 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.

AER applies to a range of savings products, including our Saga Easy Access Savings Account, Saga Cash ISA and fixed-term savings accounts on the Saga Savings Platform.

How is AER calculated?

Many factors influence how AER is calculated. These include gross interest earned in a year, compound interest and the regularity of interest payments (monthly, bi-annually or annually). 

AER is always displayed as a percentage, such as 3%. If you deposit and hold £1,000 into a savings account with 3% AER, the interest you get would be 3% of £1,000. This equals £30. 

Here’s an example of what your interest earnings would look like over three years if you deposit £10,000 into an account offering 5% AER. 

You’ll notice that the amount of interest you earn each year increases. This is known as compound interest. It's the interest you earn on your initial deposit plus the interest already added to your balance.

Is there a difference between AER and gross interest?

The key difference between AER and gross interest is that AER takes compound interest into account, and gross interest doesn’t. Because of this, AER is considered more accurate when estimating potential returns on your savings.