We all know saving money. Put some aside each month and don't touch it. It will grow. Saving money is simple. There is more to it, and almost nobody talks about it. The banks don't exactly shout about it either. It's all about the arithmetic of when. This can quietly swallow a chunk of the interest you thought you were earning.
The Rate You See Is Not the Rate You Get (On Any Given Day)
Savings accounts advertise the interest rate on an annual basis. So we convert this to a monthly figure and then move on. But actually what the bank is doing is converting the annual rate to a daily rate. It then applies this daily rate to your account balance on a daily basis and then adds it all up for the year. Most people know this. But what most people don't know is which account balance the bank uses to calculate interest on any particular day.
For the majority of British savings accounts, interest is calculated on the previous day's closing balance. So, if you move £2,000 to a savings account on the 15th of the month, that £2,000 will not earn anything until the 16th. One lost day of daily interest on £2,000 at, say, 4.5% is about 25p. However, this is a habit that, over twenty years of depositing on the same slightly-too-late day each month, adds up to somewhere in the region of sixty pounds, before compounding begins to multiply the effect.
The Month Is Not Thirty Days Long (Not to Your Bank, Anyway)
Imagine two people saving in identical accounts at identical interest rates. They both deposit the same amount of money into their accounts each month. One of them deposits on the 1st of the month and the other on the 28th. After a year the person who deposits on the 1st of the month will have earned slightly more interest. Not because they saved more, but because their money is in the account for more of its daily interest calculations.
The daily rate on a 4.5% account is roughly 0.0123% per day. Across the twenty-seven extra days of the month, on a £500 deposit, that's about £1.67 per deposit. But you have to run this forward 5 years, 10 years – with compounding ticking away the whole time. So the second of these two very responsible people is losing money, small amounts of it, quietly and consistently over time.
The Account That Looks Identical and Isn't
But it gets stranger. Two savings accounts can have the same AER (the Annual Equivalent Rate, the rate meant to make comparison simple) and yet yield different amounts depending on how frequently the bank compounds interest internally. Some compound daily, some monthly, and some credit interest annually even though they calculate it daily.
So while a bank that compounds interest monthly will earn interest on the interest earned in January from February, a bank that compounds annually will leave that same interest sitting inert until December. The AER is meant to iron out this difference and make the quoted rate equivalent regardless of compounding frequency, and in a clean mathematical sense it does. But it does not take into account the timing of your deposits. Drop money in on the last day before a monthly compounding date and you've missed a whole cycle. The deposit earns daily interest from the next day, but it doesn't get folded into the compounding calculation until the following month. The AER hasn't lied to you but it hasn't told you everything either.
What To Actually Do With This
For savings accounts, none of this means you should be anxious about savings accounts or spend hours cross-referencing compounding schedules. Just deposit as early in the month as you can manage, ideally the day your pay lands if it's a fixed monthly arrangement. Whether your account compounds interest daily or monthly matters too — it'll be in the terms, usually under 'how interest is calculated'. If two accounts have identical advertised rates, then daily compounding wins if everything else is equal.
The bigger point isn't the £1.67. It's that your savings account is running a small, quiet piece of machinery the whole time, and most people never look at the cogs. Once you know they're there, you might as well have them turning in your favour.
FAQ
When does money I pay into a savings account start earning interest?
In most British savings accounts the interest is calculated on the previous day’s closing balance so deposits will earn interest from the following day. Thus a deposit on the 15th will not start to earn interest until the 16th. On £2,000 at 4.5% this lost day would cost approx. 25p, which adds up over the years to come.
Does the day of the month I pay into my savings matter?
For most deposits there is a small advantage to paying in at the start of the month as this ensures your money is in the account for as many days as possible to earn interest on a daily basis. For example on a £500 deposit at 4.5% the twenty-seven days extra interest would be approx. £1.67 per deposit and this would also compound over time.
Does AER take account of when I make my deposits?
No. AER takes account of the frequency of compounding and is therefore meant to allow comparison of quoted rates. However, it ignores the timing of deposits into an account, which will affect the return on an investment. For example, if you pay in on the last day before a monthly compounding date, you miss a cycle and the money is not included in the compounding until the following month.
How do I find out how my savings account compounds interest?
Check the account terms, usually under ‘how interest is calculated’, to see if interest is compounded daily or monthly, or calculated daily but only credited to your account annually. If two accounts offer the same rate and all else is equal, then the account that compounds interest on a daily basis will pay more than the one with monthly compounding.
