Personal-Finance

Nominal vs effective interest rates

2016-05-12 09:09

It’s often said that compound interest is the eighth wonder of the world, but few people understand just how wondrous – or treacherous – compound interest can be.

To an investor, knowing that your money works for you with minimal input from you is lovely. For someone who has a loan, however, compound interest can be a costly phenomenon.

It helps to differentiate between simple and compound interest. A lot of people tend to confuse the two. Simple interest is a fixed percentage of the initial amount invested or borrowed. So, if you invested R1 000 and the interest was 6% a year, the amount you’d have after a year is R1 060. The amount you’d have after two and three years is R1 120 and R1 180, respectively.

Compound interest, on the other hand, is the interest earned on both the principal amount and on the accumulated interest. If we earned 6% interest annually on an investment of R1 000, the first year would reflect an amount of R1 060, the second year would reflect R1 112.36 and the amount in the third year would be R1 119.02 (rounded off to the nearest cent).

Investment vehicles get a little tricky when it comes to how frequently interest is paid out. It’s helpful to know the difference between the given nominal rate, compounded monthly, quarterly or biannually, and the effective interest rate.

For example, if you want to invest R1 000 at an annual interest rate of 12%, with interest compounded quarterly, then interest is paid in 3% increments every three months. In the first quarter, your investment would be R1 030. In the second quarter, you would have R1 060.90. The third quarter would give you R1 092.72 and in the last quarter, you would have R1 125.50 (rounded down to two decimal places). Your effective interest rate is 12.55%.

Using the same rates and capital, an annual interest rate compounded every six months would mean 6% interest is earned twice in a 12-month period. A R1 000 investment after six months would be R1 060 and, after a year, it would be R1 123.60, the effective interest rate being 12.36%.

It is important, therefore, to always understand the effective interest rate because, over time, the difference between the effective interest rate will continue to diverge from the nominal interest rate.

The same principle applies to loans, except the interest is what you pay back, not earn. In most cases, a loan compounds the interest daily, so that actually increases the effective interest rate. This is why paying additional amounts into your loan, or paying it off a few days earlier, can save you money over time. It is also the reason interest can increase so rapidly if you miss a payment.

Before taking on a loan, or choosing a savings account, make sure you’re aware of the nominal interest rate and how often interest is compounded, and ask for help to determine how much of a difference this would make to your repayment or investment.

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