AER stands for Annual Equivalent Rate, and it represents the total interest you can expect to earn on a savings or investment account over a year.
Understanding AER
The Annual Equivalent Rate (AER) is a standardized way of showing the interest you'll earn on a savings or investment account, taking into account the effect of compounding. This means that it shows the total interest you'll receive in a year, as if the interest was paid out once a year. It allows you to easily compare different accounts, regardless of how often the interest is paid.
Key Features of AER
- Annualized Rate: AER shows what the interest rate would be if the interest were compounded annually.
- Comparison Tool: Enables easy comparison of different savings and investment products.
- Includes Compounding: Takes into account the effects of compounding interest, which is crucial for understanding the true return on your investment.
Example
Imagine you have two savings accounts:
- Account A: Pays 5% interest compounded annually.
- Account B: Pays 4.9% interest compounded monthly.
At first glance, Account A might seem better. However, the AER will show you the actual annual return. Account B's monthly compounding might result in an AER that's higher than 5%, making it the better choice.
Why AER is Important
AER is a crucial figure when choosing a savings or investment account because it allows you to directly compare the interest rates of accounts with different compounding frequencies. The reference indicates that AER "indicates the percentage of interest you'll receive each year for holding savings with your bank."
How to Use AER
- Compare Accounts: When comparing different savings and investment accounts, always look at the AER to see the true annual return.
- Understand Compounding: Realize that accounts with more frequent compounding periods (e.g., monthly or daily) will often have slightly higher AERs than accounts with annual compounding, even if their stated interest rate is lower.
- Consider Other Factors: While AER is important, also consider other factors such as account fees, access restrictions, and the financial institution's reputation.
