Why do regular savings accounts seem to pay the highest rates?

Regular savings accounts will almost always beat other savings accounts in a straight comparison of headline interest rates.

Unfortunately, many people drawn in by these attractive rates are then left feeling short-changed by the amount of interest they eventually receive. Behind the disappointment is a lack of understanding over exactly how the accounts work.

The most common misconception when it comes to regular savings accounts is over how interest is applied. To help explain, and make calculations easier, we’ll use an example where a regular savings account offers a headline rate of 12%.

This will lead some savers to the erroneous conclusion that by depositing £3,000 over the course of the year – £250 per month – they will receive £360 in interest (assuming no tax is payable).

However, sadly it is not as straightforward as working out 12% of £3,000. 

In reality, there are two factors that must be taken into account.

Firstly, it must be realised that a proportion of the annual interest rate is calculated each month. So in very simple terms, if a one year account has a headline rate of 12%, savers should probably expect to receive a rate of around 1% each month.

And secondly, it should be considered that this rate of interest is only earned on the savings that are in the account at any given time.

So in the first month, 1% interest is calcualted on the first regular payment of £250 alone; in the second month, 1% interest is being earned on the £500 that has now been contributed in total, and so on. It is only when the final payment is made in the 12^th month that the full £3,000 will actually be earning interest, and the rate paid for that month will essentially be 1%.

When this is worked out fully over the 12-month term, you are looking at interest of around £195, rather than the £360 some may have originally calculated.

Some accounts pay the interest into the account each month, buy other pay it annually. It is when the interest is calculated that is important.

Regular savings accounts may be a great way to get into the savings habit, and are ideal if you have a savings goal in mind, such as Christmas, a wedding or a new car.

It could also be the case that the return they do actually pay stands up well against what other types of saving account have to offer. Importantly, however, don’t get too carried away by the headline rate, as you’ll likely end up disappointed.