AER, APR and EAR: the world of interest rates and their acronyms can seem like a murky alphabet soup. But once you understand what those three letters mean, taking out a mortgage, or a credit card or opening an savings account won’t be such a headache. In fact, the acronyms become a bit of a lifesaver, as they are designed to make sure you get the best deal possible by easily comparing what is on the market. And there is no maths involved. Promise.
AER – for saving
When you open a savings account, the bank will pay you to keep your money with them. To work out how much, the AER, or the Annual Equivalent Rate, takes everything linked to your savings account – the headline interest rate, any special bonuses and compounding – and boils it down to one handy percentage.
What is compounding? It is the magic cornerstone of finance. Let me explain. If you put £1,000 into a savings account and get 0.5% interest – like at Starling (we pay 0.5% AER on balances up to £2,000 and 0.25% on balances above £2,000 up to £85,000) – you will have £1005 in your account after a year. At the end of year two, you make interest on your interest, as well as the amount your originally invested. Now you have £1010.03. Doesn’t sound like much, but it’s the same as growing your Twitter followers – slow to reach the first few thousand and then – boom! – it starts to take off.
Back to the AER. It doesn’t matter if your savings account pays interest monthly or yearly, and it also doesn’t matter about the ‘headline rate’. Repeat after me: Just focus on the AER. Here is an example: if Savings Account A pays interest monthly at a smaller headline rate, and Savings Account B pays interest yearly at a slightly higher headline rate, but they both provide a 5% AER, it means you’ll get the same rate for both accounts over one year – 5%. (You can find several AER calculators online.)
One last thing. You pay tax on your interest every year if you gain more than £1,000 as a basic rate taxpayer or more than £500 as a higher rate taxpayer. The AER cannot take tax into account as it won’t know your individual circumstances. And remember that interest in ISAs is tax-free, whereas in savings accounts it’s not, so best not to compare apples and oranges.
APR – for borrowing
If you borrow money and pay it back, it’s likely you will pay interest on top. The acronym you need to know now is the APR, or the Annual Percentage Rate. So, if you’re taking out a loan, credit card or a mortgage, the APR tells you how much it will cost you to borrow, including any upfront charges, and is an easy way to compare products on the market.
BEWARE – without being too dramatic about it - this time, the APR does not give you the full picture of how much interest you will pay as most credit cards and loans charge compound interest. “Compounding works in your favour when you are saving and investing but the opposite is true where you have debt – and it’s really important to understand this,” Natalie Wright, a chartered financial planner at Mazars says. “If you’re only making the minimum repayments on a credit card, for example, you will effectively be paying interest on interest meaning you pay your debt off very, very slowly and you will end up paying much more interest than you need to.”
Another common trap is the “headline interest rate”, which we mentioned before. Although consumer credit agreements are legally required to advertise their APR, everyone can be tempted to zero in on the shiny, lower headline rate next to it.
Also, the APR is all well and good, but it’s not always the final story. Why? Because your own credit history – also known as your credit score – will determine the exact interest rate that a financial company is willing to give you. Having said that, if the advert says ‘representative APR’, then the lender is required by the financial regulator to offer most of its approved customers the advertised rate.
EAR – overdrafts
Last but not least, the Equivalent Annual Rate (EAR) is the cost of using your overdraft, assuming you are overdrawn for the year. The EAR does take compounding into account, but it does not include fees. So, watch out – if you’re dipping in and out of your overdraft, in theory you could be charged each time. (The good news is that Starling doesn’t charge extra fees. Our EAR interest rate is 15% and we only apply it to the amount you actually borrow. To see how we compare with other banks, check out our overdraft calculator.)
As Catherine Morgan, founder of The Money Panel and radio host of The Money Mindset Show, explains, if you’re deciding between an overdraft and a credit card, look at the APR of the credit card, the EAR of the overdraft – plus any fees – and think about what you need the money for and for how long.
And, as with anything you buy, always shop around.
“The danger is entering into a contract that you don’t fully understand,” she says. “The more you understand, the more savvy you can be and the faster you can repay your debt. Understanding the cost of credit will help you have a better relationship with money.”