How interest rates work
NOMINAL VS EFFECTIVE: KNOW DIFFERENCE WHEN YOU SAVE, BORROW
There’s a way to calculate how much will actually land in your account.
Afew years ago a local bank claimed to offer an exceptional interest rate on a cash savings product. A brief investigation by excited savers quickly revealed what they suspected: the claim sounded too good to be true because it was too good to be true.
A difference between nominal interest and effective interest is at the heart of what rubbed potential savers the wrong way.
Interest rate basics
Interest is money paid for the privilege of using other people’s money. When we save, the bank pays us for the privilege of using our money. When we borrow, we pay the bank for the privilege of using its money.
On the surface, the maths is pretty easy. Before you save or borrow money, the bank tells you how much interest you will receive (when you save) or pay (when you borrow).
For example, you decide to keep your emergency fund in a 30-day notice account with your bank. When you open the account, you are told you will receive 8% interest.
If you put R20 000, you might assume you will receive: R20 000 x 8% = R1 600 every year. However, you should ask whether the interest rate offered is a nominal or effective interest rate before you calculate how much you’ll have when you take out the money.
Nominal interest
What you see is what you get. You can think of nominal interest as the sticker price.
When the bank says you will receive 8% nominal interest, it means you will receive the same amount of interest every time.
If you left your R20 000 invested for five years and the bank calculates your interest once a year, you will receive R1 600 every year.
At the end of five years you will have 5 x 1 600 = 8 000. When you withdraw your money, you will have R28 000. Your investment grew by 40%.
Effective interest
What you see is only the beginning. As you already know, compounding is the reason why this saving and investing business actually makes us better off.
Compounding is applied to interest, whether we pay it (when we borrow) or receive it (when we save). The effective interest rate takes compounding into account.
If you saved the same R20 000 that offered an interest rate of 8%, calculated and compounded once a year, things are looking even better for you. In year one, your calculation would look the same as it did for your nominal interest rate: 20 000 x 8% = 1 600.
When the interest is paid into your account at the end of the first year, you would have: 20 000 + 1 600 = 21 600.
This is where the fun really starts, because in year two you will earn 8% on your initial R20 000, as well as the R1 600 you earned in interest. You will have: 21 600 x 8% = 1 728.
This is once again added to the money already in your account, which brings your total at the end of the second year to: 21 600 + 1 728 = 23 328. If you keep going along this route, at the end of five years, you will have R29 386.
Remember, when you earned a nominal interest rate, you only got R28 000 at the end of five years. The additional R1 386 is interest you earned on interest. Your investment grew by 43%. That means your effective interest rate is 8.6%.
Why does it ma er?
If your bank claimed you will earn 8.6% interest and you didn’t ask whether that would be nominal or effective interest, you could end up with less money than you anticipated. While the bank didn’t exactly lie when they said they offer an interest rate of 8.6%, they failed to mention the additional 0.6% is just 8% interest on your interest. It’s not wrong, but it’s not right either.
Van Heerden is a financial educator and strategist. This article was first published on Just One Lap, and is republished with permission.