Are UK cash ISA's cumulative?

Question

I have opened a Cash ISA recently and I don't seem to understand how they calculate the ISA earnings.

So as an example, suppose I have a cash ISA maxed out at £5,940 (I know this is going up in July to £15000).

So for that first month, I earn 2% = £118.8 (as an example, at a fictitious bank). For month 2, do I get paid interest on my initial sum (5940), or on the total balance of my ISA (6085.8).

So is the following, the correct way to calculate this?

initial balance: 5940

month 1 balance: 5940 + 2% = £6058.80

month 2 balance: 6058.8 + 2% = £6179.97

Answer 1

What you refer to as "cumulative" is normally called compounding.

Note that while I know your example is fictitious, but 2% per month is totally beyond the realms of possibility - 2% per year is the right order of magnitude.

Usually interest rates are quoted as annual equivalent rates (AER), which in effect means that they are compounded annually. Also, typically for ISAs interest will be paid annually so you won't even see individual monthly interest payments.

So the amount paid in the first year might be 2% of the total balance, and then the amount paid in the second year might be another 2% of that new balance. So if you replace "month" by "year" in your question then that's roughly what you should expect to see.

For other accounts, particularly current accounts, interest might be paid and compounded monthly, but the interest rate quoted will still be an AER. If you kept the same balance in the account for an entire year, then you would end up receiving the total interest quoted (e.g. 2%) but each month you would actually get a rate that's calculated to produce the same result.