Knowing the difference between APR and AER on your savings.
At Giliker Flynn, our financial advisers in Stoke On Trent often use scientific calculators when sat with clients, as growth (and losses) must be compounded in order to give a true reflection of returns. Here’s a simple example of how it works in practice:
You may have £10,000 sat in a Cash ISA with your local bank. This is earning 2% pa, and the interest is paid quarterly. If you did a quick calculation and tried to work out what it may be worth in 5 years, the simple approach would be to assume that your interest is £200 a year, and therefore the total interest paid over 5 years will be £1000. This is an incorrect trap to fall into.
The above example does not include two elements; compounding and Annual Effective Interest.
Compounding is basically your interest earning further interest! For example, in Yr 1 your ISA may be worth £10200. However in Yr 2, this would increase to £10,404, as the 2% interest would have been added to both the original £10,000, plus your extra £200. The net effect is that your ISA would be worth £11,041 in year 5. The compounding of interest has given you an extra £40!
In addition to the above, it’s also savvy to look at how often your interest is paid. 5% paid annually is actually less than 4.9% paid monthly. Knowing these quick little tips could help you to find the all important extra pounds that are so hard to come by given current interest rates.
Using the aforementioned ISA example, if the 2% interest is paid quarterly over 5 years, the actual value of the ISA would be £11,095!