The interest rate you earn on a savings account is important because it determines how much you earn when you keep your money invested. Understanding interest rates will help you make an informed decision on whether Product A is better than Product B.
One should always ask for both the nominal and ‘effective’ annual interest rates and use both figures when comparing offers. The ‘nominal’ rate refers to the interest you’d earn over the year if you withdraw that interest from the account every month. The annual ‘effective’ rate reflects the amount paid over the year if the interest is added to the account balance every month. This number reflects the true return you can expect on your investment, because it includes the effect of compound interest.
Let us take you through an Example of investing R1 000 000:
Nominal Interest:
If you left your R1,000,000 invested for five years with a nominal interest rate of 8%, and the bank calculates your interest once a year, you will receive R80,000 every year.
At the end of five years, you will have:
5 × 80,000= R400,000
When you withdraw your money, you will have R1,400,000. Your investment grew by 40%.
Effective Interest:
If you saved the same R1,000,000 that offered an interest rate of 8%, calculated and compounded once a year, the calculations would be:
In year one:
1,000,000 ×8%= R80,000
1,000,000+80,000=1,080,000
In year two:
1,080,000×8%=86,400
1,080,000+86,400=1,166,400
If you continue along this route, at the end of five years, you will have R1,469,328.
Remember, when you earned a nominal interest rate, you only got R1,400,000 at the end of five years. The additional R69,328 is interest you earned on interest. Your investment grew by 46.9%. That means you didn’t just earn 8% on your initial R1,000,000 investment. Your effective interest rate is approximately 8.6%.
Amazing to see the power of compound interest!
At the end of the day the same reasoning applies understanding the difference between nominal and effective interest rates will guide your decision-making when saving or borrowing money. Knowing how the interest is calculated allows you to make more informed financial decisions, ensuring that you won’t end up with less money than anticipated or pay more than expected when borrowing. Whether you are saving or borrowing a substantial sum like R1,000,000 or a smaller amount, these principles remain the same and can significantly impact your financial well-being.
Stay informed!
Source article: https://justonelap.com/wealthy-maths-nominal-vs-effective-interest/
