When comparing interest rates in savings accounts, loans, mortages etc, you may see the interest described in two ways. Firstly a gross rate which may or may not reflect the actual interest you will earn in a year and secondly, AER (Annual equivalent rate) which is a more accurate representation of the interest you will receive.

##### Compounding frquency

Interest can be calculated at different intervals, if the interest is evaluated just once a year say at the end of the financial or calendar year, then the gross rate and AER will be the same.

The difference happens when interest is evaluated more frequently than once a year. If your interest is evaluated monthly for instance, the gross interest rate is divided by 12 and that amount is added on a monthly basis instead of in one lump. As an example, a gross interest rate of 5% calculated monthly will be applied as 0.416% 12 times throughout the year.

##### Why does this matter?

Well each time that small amount of interest is applied, there is a slightly higher amount for the next set of interest to be applied to. This means that even though your gross rate is quoted at 5%, the actual amount of interest you gain over the same 1 year period with monthly compounding is 5.116% and this would be your AER.

Comparing true AER is the best way to compare two different interest rates. For a more comprehensive explanation, click the link below to read more.