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A savings interest rate is the percentage used to calculate how much money a financial provider, such as a bank or building society, pays you for keeping your savings with them. While the maths behind savings interest is relatively straightforward, terms such as Gross, AER, fixed rates, variable rates and compound interest can make it feel more complicated than it really is.
Understanding how interest works can help you make informed decisions and choose a savings account that meets your needs. Whether you’re building an emergency fund or saving towards a future goal, earning interest can help your savings grow over time.
This article will break down what an interest rate on a savings account is, how interest is calculated on savings accounts, the difference between simple and compound interest, and how to maximise your savings.
What is an interest rate on a savings account?
The interest rate on your savings account is used to calculate how much interest you earn on the money you save. The amount of interest you receive will depend on the rate offered by your provider, how much money you save and how long your money remains in the account.
Banks and building societies pay interest in return for holding your money, which they may use as part of their wider lending activities. For example, at Hinckley & Rugby, savings deposited by our members help support lending to other members who are buying a home. Importantly, your savings and any interest earned remain yours and can still be accessed in line with the terms of your account.
How is interest calculated on savings accounts?
Understanding how interest is calculated on savings accounts can feel confusing at first, but it’s usually quite straightforward. Most banks and building societies calculate interest daily based on your account balance at the end of each day.
Daily interest calculator
To calculate how much interest your money earns on any given day, banks and building societies use the following calculation:
Daily interest = Account Balance x Annual Interest Rate ÷ 365
At the end of each day, your account balance is multiplied by the annual interest rate and divided by 365 days (or 366 during a leap year). These daily amounts build up over time and are paid into your account according to your account terms, such as monthly, annually or when the account matures.
How does interest work on a savings account?
Interest can be calculated in different ways, which can affect how much your savings grow over time. The two main methods are simple interest and compound interest:
- Simple interest: interest is paid away from the account rather than added back into it. That means you only earn interest on the money you have deposited, not on previous interest payments.
- Compound interest: interest is calculated on your savings balance and any interest previously earned, meaning you can earn interest on interest over time.
Gross Rate vs AER
When comparing savings accounts, you’ll often come across two terms: Gross Rate and Annual Equivalent Rate (AER). Understanding the difference can help you compare accounts more easily.
- Gross rate: the stated interest rate used to calculate the interest paid on your savings.
- Annual equivalent rate: shows the interest you would earn over a year, including the effect of compounding if interest is added to the account during the year. Because all providers calculate AER in the same way, it helps you compare savings accounts more easily.
Example calculation
Here is an example calculation based on placing £5,000 into a savings account with an interest rate of 4.50% AER with interest compounded monthly, and no further deposits or withdrawals are made.
| Period | Starting Balance | Interest Earned | Closing Balance |
| Month 1 | £5,000 | £18.75 | £5,018.75 |
| Month 2 | £5,018.75 | £18.82 | £5,037.57 |
| Month 6 | £5,094.45 | £19.10 | £5,113.56 |
| Month 12 | £5,210.16 | £19.53 | £5,229.69 |
Savings and interest at banks vs. building societies
While banks and building societies both pay interest on savings and use customer deposits to support lending, there are differences in how they are owned and how profits are used.
- Banks: A bank pays interest on your savings and uses customer deposits to support lending and other business activities. If the bank makes a profit, it may distribute some of that profit to its shareholders.
- Building societies: A building society also pays interest on savings and uses customer deposits to support lending. However, building societies are owned by their members rather than shareholders. This means profits can be reinvested into the society, helping to support its long-term financial strength and the products and services it offers to members.
Fixed Interest Vs Variable Interest
Savings accounts typically offer either a fixed or variable interest rate. With a fixed interest rate, the rate will stay the same for a set period, so you’ll know exactly what rate of interest your savings will earn during that time. With a variable interest rate, the rate can increase or decrease. Providers may review variable rates based on factors such as changes to the Bank of England base rate, market conditions and rates offered by competitors.
Do you pay tax on savings interest in the UK?
Many people do not pay tax on the interest earned from their savings because of tax allowances set by HMRC. Depending on your Income Tax band, you may be able to earn up to £1,000 in savings interest each tax year before paying tax. This is known as your Personal Savings Allowance (PSA).
Personal Savings Allowance (PSA)
The amount of tax you pay on savings interest will depend on your individual circumstances. Tax rules and allowances can also change over time, so for the latest information, visit https://www.gov.uk/apply-tax-free-interest-on-savings.
If you think you are going to exceed your Personal Savings Allowance, you could choose to save in a Cash ISA. Any interest earned inside a Cash ISA is 100% tax-free and doesn’t count towards your PSA.
If you’re still wondering, ‘How does interest work on a savings account?’ or ‘How is interest calculated on savings accounts?’ Our friendly team is here to help. You can explore our range of savings accounts or get in touch with us at Hinckley & Rugby Building Society. We’ll be happy to explain how our accounts work and answer any questions you may have, so you can feel confident about earning interest on your savings.
