Annual Equivalent Rate (AER)
A notional rate quoted on the interest paid on investments and savings.
The annual equivalent rate (AER) is supposed to demonstrate your prospective return if the interest was compounded and paid annually instead of, for example, monthly. It is interest calculated on the basis that any interest paid is combined with the original balance, with the next interest payment being based on the slightly higher account balance.
How is the AER calculated?
The formula for AER is (1 + i/n)n – 1, where ‘i’ is the stated annual interest rate and ‘n’ is the number of compounding periods in a year.Practical Application Example
“
If you purchase a certificate deposit (CD) with a stated annual interest rate of 12% and the bank compounds the interest every month – i.e. 12 times a year – the AER on the CD will be calculated as follows: (1 + 0.12/12)12 – 1 = 0.12683 or 12.683%. So if you put £1,000 into the 12% CD, after 12 months, you can expect the balance to be £1,126.83, on the basis that (£1,126.83 - £1,000)/£1,000 = 0.12683 or 12.683%. ”
