Money Guide
APR AER AND EAR
When a product provider quotes an interest rate, it is not always immediately apparent how much you will be paying - or be paid - if you take out the product. When shopping around for savings accounts, for example, different providers may choose to quote monthly or annual interest rates, making it difficult to compare accounts fairly.
When it comes to loans and mortgages, some lenders charge hefty upfront fees, and low interest rates, while others charge low fees and high interest rates.
This is where measures such as the annual equivalent rates (AER) and annual percentage rate (APR) come in handy. These are calculated in the same way across providers. If you are trying to compare accounts, look for these, rather than the headline rate.
Annual percentage rate (APR)
An APR is used as a measure of how much it costs to borrow money and is quoted by mortgage lenders and companies offering personal loans and credit cards. The APR includes any upfront fees charged by the lender, spread over the period for which you are borrowing the money.
The APR tells you how much your borrowing will cost over the course of a year, as a proportion of the amount you have borrowed. So if you are borrowing £100 at an APR of 9%, you will pay £9 in interest and charges over the first year.
Interest APR mortgage Mortgage lenders will advertise a headline rate and an APR. Photograph: Linda Nylind In a loan advert, the provider will often quote a "typical APR" - this is because many lenders set the actual interest rate charged according to the borrower's credit record and personal circumstances. A bank has to have offered its typical APR (or a better rate) to at least 66% of potential customers.
In a mortgage advert, the lender will usually quote a headline rate as well as the APR. Most lenders charge administration fees on mortgages, so APRs tend to be much higher than the headline rates.
Equivalent annual rate (EAR)
Like the APR, an EAR is quoted when you are borrowing money - this time in the form of an overdraft. Unlike an APR, this doesn't include any fees for going overdrawn. Instead, it gives you an idea of how much your borrowing will cost if you were to remain overdrawn for a whole year.
The calculations take into account the rate of interest being charged, how often it is charged, and the effect of compounding it - charging interest on interest - over the year.
Annual equivalent rate (AER)
An AER is quoted on savings accounts and current accounts for when your balance is in credit. It is like the EAR but refers to interest earned, rather than paid. The AER shows how much interest you will earn over the course of a year and takes into account how often the interest is paid and what effect compounding will have.
This measure allows you to compare how much you will earn on an account where interest is paid monthly with one where interest is paid annually.
Piggy bank AERs allow you to compare accounts and work out where your savings will earn most. Photograph: Getty The gross rate paid on an account offering monthly interest may be lower than the gross rate on an account offering only one interest payment a year, but when interest is compounded it may offer higher returns than the latter account.
For example, an account offering a rate of 6.25% paid annually may look more attractive than an account paying 6.12% with monthly interest payments, however the AER on the monthly account is 6.29%, as opposed to an AER of 6.25% on the account with annual interest payments.
If there is a charge for withdrawing your money, the AER will take this into account - so, for example, if you are charged 30 days' interest for a withdrawal, this will be reflected in the AER.
If an account includes an introductory bonus for a few months, you should be told whether or not this is in included in the AER. If it is not, looking at the AER will enable you to compare it fairly with an account that offers a level rate of interest all year.
Pensions
A personal pension is a savings scheme designed to pay out when you finish work. You may be able to survive on the state pension, but if you want extra income a personal pension is one way to provide it.
Broadly speaking, there are three types of personal pension: stakeholder, standard and self-invested personal pensions (Sipps). Which type is suitable for you depends on how involved you want to be in your investment, your attitude to risk, and the amount you can afford to save.
Whichever you choose, you will make regular contributions into the scheme until you choose to retire. The money will be invested on your behalf, and your fund will grow in line with the performance of the investments.
When you reach retirement you will be able to take up to 25% of your fund as a tax-free lump sum, and use the rest to provide an income for the rest of your life.
Remember, the earlier you start paying into a pension, the longer it has to grow so you can retire on a comfortable income.
Maximum contributions
Pension book Tax relief is available on your savings to help boost the amount you retire on. Photograph: Graeme Robertson/Getty You can pay up to £225,000 a year in total into all your personal and employer pension pots, with a lifetime limit on the fund of £1.6m. This is set to rise to £1.8m by 2010-11.
However, you only get tax relief on a sum equivalent to 100% of your earnings.
If you are not earning, perhaps because you have taken a career break, you can still pay into a personal pension provider, but your contributions are limited to £3,600 a year, after tax-relief.
Tax-relief on personal pensions
To encourage you to save for retirement the government boosts your contributions to a personal pension by your highest rate of income tax. So, for example, if you are a basic-rate taxpayer and you want to make a £1,000 contribution to a pension plan, it will only cost you £780 with the taxman topping up your contribution with the balance of £220.
For a higher-rate taxpayer the relief is worth 40%, but only 22% is paid straight into your mention. You have to reclaim the difference between basic and higher-rate tax relief through your annual tax return.
Stakeholder personal pensions
These are the simplest form of personal pension and are designed for people seeking a no-fuss retirement savings vehicle. The investment choice is limited, usually to the pension provider's in-house funds.
Stakeholder schemes are low-cost and provide easy access for savers. The rules state that providers must accept payments of just £20, and the maximum they can charge for the scheme is 1.5% a year.
The provider cannot charge members for transferring money into or out of a stakeholder scheme.
Standard personal pensions
Pensioners taking financial advice You can seek advice to find out which pension is most suitable for you. Photograph: Ryan McVay/Getty These offer more investment choice than stakeholder plans, with between 40 and 400 funds available from a range of managers.
Many personal pension providers have now brought their plans in line with the stakeholder model, capping charges at 1.5% a year for the first 10 years and 1% thereafter.
In the past, personal pensions were severely criticised for applying steep charges without limit. They were renowned for using a process called 'front-end loading', meaning they levied very high initial charges, sometimes equivalent to 80% of the first year's contributions.
Be aware there is still no limit on personal pension charges outside a stakeholder, so check what these are before you apply.
Self-invested personal pensions (Sipps)
These are a step on from standard personal pensions and give a wider investment choice, usually at a higher cost. For those wanting to pick and choose the funds in which their pension invests, a Sipp may be a suitable choice.
These benefit from the same tax relief as standard personal pensions, providing the investments are on HM Revenue & Custom's approved list. This includes life insurers, commercial property, unit and investment trusts, equities, cash deposits, and futures and options.
Dealing charges and management fees vary dramatically between providers, and can be hefty, making Sipps traditionally suited to high-net worth individuals.
As well as set-up charges of between £400 and £500, and annual charges of around the same sum, you face initial and annual charges for each investment made.
However, newer stakeholder-style contracts with lower charges are gradually being introduced,, giving Sipps wider appeal - although you can't invest in commercial property through these.
Sipps are available from independent financial advisers and stockbrokers, as well as from traditional pension providers.
ISA
An Isa is a tax-efficient "wrapper" in which you can hold either stock market-based investments or a traditional savings account.
Any interest earned on savings or bonds and any capital gains made on investments within an Isa are tax-free. This makes Isas particularly appealing to higher-rate taxpayers, who usually have to hand over 40% of their returns to the taxman.
Isas replaced personal equity plans (Peps) and the tax exempt special savings accounts (Tessas), which closed to new investors in April 1999. Two types of Isas are available: stocks and shares Isas and cash Isas.
Because of the tax breaks, the amount you can invest in an Isa each tax year is limited - currently, the limit is £7,200. How you divide this money up depends on what kind of assets you want to hold in your Isa.
Investment limits
The old distinctions between maxi and mini Isas no longer exist - they were scrapped in April 2008.
Instead you can invest your £7,200 allowance in two ways:
·Put all £7,200 in stocks and shares, or
· Up to £3,600 in cash and the balance in stocks and shares
You can take a cash Isa from one provider and put the remainder of your overall allowance in a stocks and shares Isa from another provider, or hold it all with the same company.
Once you have invested your annual limit you cannot pay more in, even if you have made a withdrawal. Say, for example, you pay in the full £7,200 but take out £2,000 the next month, you cannot put that £2,000 back in your Isa in the same tax year. Your Isa holding may be below the limit but you will be deemed to have used your annual allowance.
Cash Isas
Sterling Cash Isas tend to offer higher rates of interest than conventional savings accounts. Photograph: PA
A cash Isa is a tax-free savings account, usually offered by a bank or building society. It will keep your initial investment intact, plus usually offering a higher rate of interest than taxed accounts from the same bank or building society which you will receive without paying tax.
Some Isa providers offer cash funds, which invest in the money markets and target a set return above the Bank of England base rate. In exchange for greater potential return you will pay an annual management fee and may be locked into the investment for a set term.
Stocks and shares Isas
Also referred to as equity Isas. A stocks and shares Isa can hold an investment fund or funds, or individual stocks and shares. This type of Isa carries risks, and should be regarded as a medium to long-term investment.
The Isa rules allow you to invest your full £7,200 allowance in stocks and shares if you choose. But if you want to reduce your risk, you may prefer to hold some of the allowance in cash.
Stock market Equity Isas should be viewed as a medium- to long-term investment. Photograph: AP
If you want instant access to your money, a cash Isa will probably suit you better. But if you are thinking of investing money you can afford to lock away for the future, you should consider shares.
If you wish to invest in a range of funds from different providers - or to benefit from lower initial charges - it is worth considering using a fund supermarket, either directly or through an independent financial adviser (IFA), or a discount broker. These will offer a menu of funds from which you can choose a selection, subject to minimum investment levels in each.
Self-select Isas
These are designed for investors who want to hold individual stocks and shares in the tax-efficient Isa wrapper and are offered by stockbrokers and online share-dealing sites.
An investor can buy up to £7,200 worth of shares through the Isa provider. As with share deals done outside the wrapper, there will be costs associated with buying and selling stocks. These will be on top of any charge for the Isa wrapper.
Tax advantages
Basic-rate taxpayers who are usually taxed at 20% on interest earned on savings accounts and bond funds do not pay a penny on interest earned on a cash Isa. Higher-rate taxpayers make bigger tax savings, as they usually face 40% tax.
The tax benefits on stocks and shares Isas are not as good as when they were first launched. Initially, investors could reclaim the 10% tax paid on dividends (income paid to people who hold shares), however in April 2004 the 10% dividend tax credit was scrapped, so for basic-rate taxpayers dividends are taxed as outside the Isa wrapper.
Higher-rate taxpayers still gain from holding dividend-producing shares in an Isa - they pay tax at 10% rather than the 32.5% that is deducted on non-Isa investments.
Profits from shares held in an Isa are not subject to capital gains tax CGT, which means any growth on your investment is all yours. You don't even have to declare your Isa on your tax return.
Transferring your money
You can transfer Isas from a previous tax year from one provider to another without having an impact on the current year's allowance.
However, most of the best-buy cash Isas don't accept transfers in, so if you are shopping around for a new home for last year's cash Isa you need to make sure you read the small print before comparing rates.
Until April 2008 you could not move money between stocks and shares and cash Isas, but the rules have changed.
Investors are now able to transfer money from a cash Isa into a stocks and shares Isa. If the cash Isa was from a previous tax year they can move as much or a little as they like.
If the cash Isa is from the current tax year, they must move all of it. They will, however, be free to invest up to £3,600 in another cash Isa, subject to the overall investment limit of £7,200.
Transfers from stocks to cash are not allowed.
