What is AER?

Seeing AER next to a savings rate is a bit like seeing "I agree to the terms and conditions". You just nod and carry on. But unlike the terms and conditions, this one is mercifully shorter, and you don’t need a lawyer to break it down for you. It's also the reason why a rate paid monthly and a rate paid yearly can look identical on the page and still pay different amounts.

What does AER mean?

AER is short for Annual Equivalent Rate. It's one yearly figure that tells you what a savings account pays, with the effect of compounding already folded in, so you don't have to work out the difference yourself.

The figure comes with two assumptions. You leave your money in the account for the full year, along with any interest it earns, and the rate stays the same throughout. If either of those changes, so will what you end up with.

That tidy, like-for-like quality is why AER is the standard way banks and building societies show savings rates. Every account gets measured with the same tape, however its interest happens to be paid.

How does AER work?

Savings providers don't all pay interest on the same schedule. Some pay monthly, some once a year, so two headline rates can look alike while behaving differently. AER translates each one into a single yearly figure you can line up side by side.

The translation hinges on compounding, which simply means interest earning interest. It behaves like a rumour in the office; each retelling gets added to the last version, so the next person hears something a bit bigger than the original. Once interest lands in your account, it joins the pot that earns the next round of interest.

Here's a worked example, using an illustrative rate rather than a real one. Put £1,000 at 5% AER and leave it alone, and after year one you have £1,050. In year two you earn interest on £1,050, not £1,000, so that's £52.50 more, taking you to £1,102.50. The extra £2.50 is the rumour growing.

How is AER calculated, and how does it differ from gross interest?

You don't need to do the maths. Providers work out AER and publish it, so the sums are done before the number reaches you. What's worth understanding is the gap between AER and the gross rate, which is the headline rate before tax, without compounding counted.

If interest is paid once a year, the two are identical: a 2% gross rate is 2% AER. If interest is paid more often and left in the account, AER comes out slightly higher, because each payment starts earning interest of its own.

Take 2% gross, paid monthly into the account. That works out at about 2.02% AER. On £1,000 left in for a year, that's roughly £20.18, versus £20.00 if the same 2% were paid once a year. Hardly a sum to retire on, but it's the reason two accounts with the same headline rate aren't always twins.

AER vs APR: what's the difference?

Think of it like this: AER is for money coming to you, and APR is for money leaving you. AER belongs to savings. APR (Annual Percentage Rate) belongs to borrowing, such as loans and credit cards, where it shows the yearly cost of the debt, covering interest plus certain mandatory charges.

The last row is the one to remember, because the two numbers pull in opposite directions. With AER, higher works in your favour. With APR, higher works against you. Mixing them up is how someone ends up cheering for a high credit card rate.

AER vs APY: why two names?

APY stands for Annual Percentage Yield, and it's the same idea as AER: a yearly rate with compounding folded in. The difference is the label, not the maths. AER is the name on savings accounts in Europe and the UK, while APY is the label used in the US and in plenty of other markets. Think chips and fries; same potato, different side of the Atlantic.

So when you compare an AER with an APY, you're comparing like with like on the maths.

One caution that has nothing to do with the name: two products can show the same kind of number and still differ in how certain the rate is, how easily you can reach your money, and what protects it. It's worth checking what sits behind any rate.

What AER doesn't tell you

A high AER is not the whole story. It measures interest and nothing else, so a few important things sit outside it:

• Fees, withdrawal limits and penalties: AER says nothing about whether getting your money out costs you.
• Tax: What you actually keep depends on your circumstances. Tax can reduce your interest, so check the current limits.
• Whether the rate can change: AER is a snapshot of today's rate, and variable rates can go up or down.
• Whether part of the rate is a temporary bonus: Some rates include one that drops after a set period.
• Whether interest stays in the account: If it's paid out rather than left in, you lose the compounding that AER assumes.

AER is the appetiser. The terms are the main course.

The bottom line on AER

That's the whole mystery. Three letters that looked as though they needed a finance degree turn out to need little more than a cup of tea. You're now officially in on it, so the next time AER turns up beside a savings rate, your nod can finally be an informed one.