What difference does it make if interest is paid monthly or annually?
The more often interest is paid or credited, the higher the effective return. This is because interest credited to an account itself earns interest – called 'compounding'. The AER (see above) takes account of the effect of compounding. With some accounts you can choose how often to have interest paid – monthly, quarterly or yearly.
Usually, the AER is the same whichever option you choose, but the advertised rate (which does not take into account compounding) will be lower the more frequently interest is paid or credited. For example, an account has an AER of 5 per cent and you can choose to have interest credited monthly or yearly. The advertised rate for the yearly option is 5 per cent but the advertised rate for the monthly option is 4.89 per cent.
Despite the lower advertised rate, the monthly option offers you the same return (as shown by the AER) because you get the benefit of interest being paid earlier.
