# Why is the gross rate lower than AER rate?

While looking at the interest rates of the Club Lloyds account, I noticed it says 4% AER rate, but then it says 3,93% gross rate. I've read three sites on what these rates are about, but I still can't understand why they have different values.

From what I understood, both are rates BEFORE tax, so why are these values different?

Let's say we have an investment with a 12% gross rate, compounded monthly. We invest a million pounds. That works out to a 1% rate per month.

`````` 0 1,000,000.00
1 1,010,000.00
2 1,020,100.00
3 1,030,301.00
4 1,040,604.01
5 1,051,010.05
6 1,061,520.15
7 1,072,135.35
8 1,082,856.71
9 1,093,685.28
10 1,104,622.13
11 1,115,668.35
12 1,126,825.03
``````

So after twelve months of compounding, we have a number that is 12.682503% higher than the original. So we might say that our AER is 12.7%. If we had simply multiplied our original amount by 1.127, we would have almost gotten the right answer.

Note that your actual bank may handle rounding differently. Also, 12% is clearly a ridiculous interest rate. I picked it for easy division and multiplication, not realism. Similarly, compounding is more likely to be daily than monthly. But I'm way too lazy to write out 366 lines of investment numbers. And of course I don't actually have a million pounds to invest. I just didn't want to round off after just a couple digits.

Any taxes would have been paid out of a separate account or perhaps this is some kind of tax free account. Again, purely for convenience.

• Thanks! I see what compounding is now! Nice explanation :) Commented Dec 7, 2016 at 19:57
• And if interest is paid monthly, then the gross AER looks better in adverts/marketing! Commented Dec 8, 2016 at 12:09