When looking for a new loan, one of the most important terms you will come across is the annual equivalent rate. But, what is AER and, more importantly, how can calculating AER help you choose the best loan?
In this article, we will thoroughly explain what AER is, how to calculate it, and what its implications may be. We’ll then look at the differences between AER and other interest rates, such as gross interest rate, APR, and EAR. So, whether you’re looking for a new loan or want to understand the terminology better, read on!
- What Is AER Interest?
- Differences Between AER and Gross Interest Rate
- AER and Compound Interest
- How to Calculate AER?
- AER vs APR
- AER vs Stated Interest Rate
- AER vs EAR
- AER Pros and Cons
- Wrap Up
What Is AER Interest?
Simply put, AER stands for the annual equivalent rate. It’s a way of expressing the actual cost of borrowing, taking into account not only the interest rate but also any other charges that may apply. The nature of AER makes it different from other interest rates such as APR (annual percentage rate), which don’t include these extras.
Additionally, AER is always expressed as a percentage, whereas APR can be expressed as a percentage or a pound and pence figure.
So, AER interest is the amount of money earned (or paid) on an investment over a year, expressed as a percentage of the original investment. For example, if you have £1000 in savings with an AER of 0.50%, you would have earned £50 in interest at the end of the year.
You can calculate the AER for any type of investment, including savings accounts, bonds, and shares. It’s a useful way to compare different investments and therefore make better financial decisions.
What Is AER Interest Used for?
AER interest is particularly crucial for long-term investments, such as pensions and endowments. These products rely on the power of compound interest to grow over time, meaning you should opt for one that offers a high AER.
It’s worth noting that AER is not for investors only. If you’re taking out a loan or credit card, you should also check the AER, as this will give you an idea of how much the loan will cost you in interest.
When comparing two investment products, the higher AER is usually the better choice. However, keep in mind that AER is not the only factor to consider when making an investment decision. You should also take into account the additional costs, such as charges for setting up a savings account, as well as your overall financial goals.
Differences Between AER and Gross Interest Rate
The gross interest rate is the proportion of a loan, for example, payable before any tax is deducted. So, let’s say you have a savings account with a gross interest rate of 0.50%. In this scenario, you will earn £50 interest on every £1,000 you have saved. However, you will also have to pay income tax on this amount, so the actual amount you receive will be less than £1,050.
When looking into the gross interest rate, don’t make the mistake of believing the gross interest rate takes into account other charges that may apply. Additionally, the gross interest rate isn’t the same as net interest, which is the interest rate earned after taxes and other liabilities have been removed.
AER and Compound Interest
Compound interest is when interest is earned not only on the original investment but also on the interest that has been previously accumulated. The compound percentages could significantly impact the growth of an investment over time, as you will see in the example below.
We’ll use the example from the previous section to give you a better idea of the compound interest. So, for £1,000 that goes into a savings account with an AER of 0.50%, you would have earned £50 in interest, assuming you didn’t make any withdrawals. This £50 would then be added to your original investment, so the account would now be worth £1,050 before any tax deductions.
The following year, you would earn interest not only on your original investment of £1,000 but also on the £50 in interest that has been earned. That would result in a total interest of £52.50, meaning the account would now be worth £1,052.50. As you can see, compound interest can have a snowball effect on investment over time.
How Often Is Interest Compounded?
Interest can be compounded daily, monthly, quarterly, or even annually. Naturally, the more times it is compounded, the higher the AER will be. However, compounding more often also means that you’ll have to pay more attention to your account to make sure you’re not being charged any unnecessary fees.
Most savings accounts compound interest monthly, while some bonds and investment products compound interest daily or even quarterly. That being the case, you should always check the terms and conditions of any product before you invest, as this will tell you how often interest is compounded.
How to Calculate AER?
The easiest way to calculate AER is to use a financial calculator. That will allow you to input the amount you have invested, the frequency of compounding, and the length of time over which the investment will be made. The calculator will then give you an AER for that product.
If you don’t have a financial calculator, you can use the following formula to calculate AER:
AER = (1+r/n)^n-1
In this equation, r stands for interest rate per annum, while n refers to the number of compounding periods per annum.
What’s more, you can rearrange this equation to solve for any of the three variables, given the other two. So, for example, if you know the AER and want to find out the interest rate or loan amount, use the following:
r = n(AER+100)^(n-100) – n
A = nr/[(AER+100)^n-100]
Surprisingly enough, the formula applies to interest rates on loans or credit cards as well. So, if you want to solve this equation, enter the amount you owe, the frequency of compounding, and the number of years you will be paying it off.
Don’t let this seemingly complicated formula scare you if you’re trying to calculate your AER for the first time. As long as you’re familiar with the aforementioned components of the formula, you’ll find your way to calculating the AER.
This formula is an important figure to know when investing. By understanding what it is and how to calculate it, you can make sure you’re getting the best return on your money.
More importantly, AER calculations apply if you plan on keeping the money in your account for an entire year. If you empty your account of funds before the year ends, you will only earn interest on the amount of time the money was in your account.
How to Use the AER Formula?
Now that you know how to calculate AER, you may be wondering when it’s appropriate to use the formula. As stated earlier, you can use the AER formula in two different ways:
- To find the interest rate on a loan or credit card
- To find the annual interest rate on an investment product
Whether you’re trying to calculate the interest rate on an investment or a loan, you will, as expected, need to become familiar with the frequency of compounding. However, when it comes to loan or credit card interest rates, you will need to know the amount you own and the length of your agreement with the bank.
On the other hand, the only additional information you’ll need to calculate the interest rate on your investments is the length of your investment.
For example, if you’re considering a five-year certificate of deposit (CD) with an interest rate of 12%, you would use the AER formula to determine how much interest you would earn over the five years.
You would input the following information into the equation:
- The length of the investment (five years)
- The interest rate (12%)
- The frequency of compounding (monthly)
This would give you an AER of 12.36%. The calculation shows you would earn £12.36 in interest for every £100 you invest.
What Does 1.5% AER Mean?
When a savings account has a 1.5% AER, the account will earn 1.5% interest yearly. This interest is compounded monthly, so you’ll earn a small amount of interest on your balance every month.
The 1.5% AER may not seem like much, but it can undoubtedly add up over time. Namely, if you have £100 on your savings account with an AER of 0.75%, you’ll earn £0.75 interest after one year. However, the same amount of money with an AER of 1.5% will earn you £1.5 interest after one year.
AER vs APR
Now that you know what AER is, you may be wondering how it differs from APR. APR stands for Annual Percentage Rate, usually charged on a loan or credit card. It’s the total cost of a loan to a borrower — including fees and other charges.
For example, if you have a £100 loan with an APR of 20%, you’ll owe £120 after one year. That is because the 20% APR interest includes the interest charge of £20 and any other fees that may apply.
However, AER is the actual interest rate of an investment. As it doesn’t include any fees or charges, it’s a more accurate way to compare different products.
But, which one is more significant when comparing investments? Surprisingly enough, every financial advisor will tell you it would be best to examine both. These simple calculations will help you determine how much interest you’ll pay on the product, meaning they’re both useful when comparing credit cards or loan opportunities.
AER vs Stated Interest Rate
The stated interest rate is the annual interest rate that the bank or financial institution advertises. But, similarly to APR, it doesn’t consider any additional charges.
For example, if you see an advertisement for a savings account with a “12% interest rate,” this is the stated interest rate. However, the actual AER will be lower, and you won’t see the true potential of an investment account before the fees are applied. So, when comparing investment choices, pay attention to the AER rather than the stated interest rate.
AER vs EAR
People often confuse AER with EAR, and for a good reason. Therefore, one of the main things to remember is that EAR takes into account the compounding frequency, giving you a more accurate estimate of the interest.
If you have a savings account with a monthly compounding frequency, the AER will be higher than the EAR. That is because the EAR includes the interest that has been compounded in the previous month.
As the EAR considers this, it provides a precise prediction of the interest you might receive on a certain investment. With that in mind, it’s advisable to pay more attention to EAR when scouting information for your next financial decision.
AER Pros and Cons
Now that you know what AER is and how to calculate it let’s look at the pros and cons of using this equation.
- An accurate way to compare investment products
- Includes fees and charges
- Offers a simple way to calculate the return of investment (ROI)
Despite the advantages of using AER, there are some drawbacks that you should be aware of. One of the main disadvantages, for starters, is that it can be confusing to use. Another drawback of using AER is that it’s not as widely used as other methods of calculating interest, such as APR.
- Investors have to calculate it manually
- Not as widely used as other methods of calculating interest
Despite the drawbacks, the AER is still a valuable equation to know. So, the next time you’re on the lookout for new investment products, remember what you’ve learned today about the AER calculation.
The AER is an excellent option to consider when taking a loan for those struggling to make accurate financial decisions. That is because understanding how to calculate AER can help you make better-informed decisions about your finances.
In this article, you’ve learned what AER is and how to use the AER formula and the pros and cons of using this equation. So, if you ever need to calculate the interest on an investment product, you now know how to do it! Thanks for reading, and good luck with your investments!