What Is annual equivalent rate (AER)?
Annual equivalent rate is usually abbreviated to AER. It is a figure that helps you calculate your true annual earnings from a savings account or investment, and easily compare accounts that pay interest at different intervals.
This is necessary because an account’s gross “interest rate” doesn’t consider compound interest at all.
As such, AER will always be higher than the gross interest rate, as long as it is calculated for more than one compounding period.
AER is sometimes known as the effective annual interest rate or annual percentage yield (APY).
A practical example of when AER comes in handy
John attempts to compare two savings accounts:
- Account A has an “interest rate” of 3.7% and pays interest monthly;
- Account B has an “interest rate” of 3.71% and pays interest annually.
If the AER isn’t stated, John will have to calculate the compound interest himself, which isn’t easy. The AER makes it simple for him to choose the best rate.
How to Calculate AER
- Divide the gross interest rate by the number of times a year that interest is paid.
- Add one.
- Raise the result by the power of the number of times a year that interest is paid.
- Subtract one.
- Express as a percentage.
So for a savings account with a 5% gross interest rate that pays interest monthly…
- 0.05/12 = 0.00416666666
- 0.00416666666 + 1 = 1.00416666666
- 1.00416666667^12 = 1.05116189788
- 1.05116189788 -1 = 0.05116189788
- AER = 5.11%
Note: When interest is paid annually, the AER will be the same as the gross interest rate.
What is the difference between APR and AER?
APR considers charges and fees, while AER doesn’t.
APR is used to calculate the total cost of mortgages and loans, because these often have huge one-off fees attached to them that should be considered by borrowers.
Savings accounts rarely have any fees attached to them, which is why AER is used instead.
In the extremely common case of a savings account having no fees attached, the AER and APR would technically be the same.
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