One of the things that inspires us to save is the interest we earn from our savings. When you open a savings account, you’ll often see interest rates classified as nominal or effective. But what does this mean?
We take a look at the difference between the two, to help you get the best value for your savings.
What is a nominal interest rate?
A nominal rate is the interest that’s calculated with the understanding that you will invest in the product for at least a year, but withdraw the interest every month, notes Himal Parbhoo, CEO of FNB Cash Investments. It’s a simple form of interest that’s added to the principal amount you have saved.
“To determine the interest earned for a particular month, you would need to take the nominal rate, divide it by 365 and then multiply it by the number of days in that month,” says Parbhoo.
He gives the following example.
Let’s assume you have R100,000 to invest. If the quoted nominal rate is 6.75%, your return would be calculated as follows:
Nominal interest = principal amount x nominal rate of interest x time period ÷ 100
6.75% ÷ 365 x R100,000 x 31 = R573.29 (interest paid over 31 days), or
R100,000 x 6.75% = R6 750.00 (interest paid over full year).
How is it different from the effective rate?
The annual effective rate is the rate of interest earned over a one-year period, assuming that all interest earned is reinvested into the deposit on a monthly basis.
“This rate, therefore, takes into account compound interest, in that you’re earning interest on top of the previous month’s investment that includes the previous month’s interest too,” says Parbhoo.
It assumes that the capital amount grows each month, so your investment will be compounded over the year, he explains.
The formula for calculating the annual effective rate is illustrated below.
Effective annual interest rate = (1 + (nominal rate ÷ number of compounding periods)) ^ (number of compounding periods) - 1
Using the same example of R100,000 investment at a nominal rate of 6.75%, the annual effective rate will be calculated as follows:
(1 + (6.75% ÷ 12)) ^ 12-1 = 6.962%
“This means that over a period of 12 full months, without any interest rate fluctuations, or any client-initiated changes to the principal amount, and adding compounding interest to the capital amount monthly, the total interest earned over the 12-month period is R6,926.77,” explains Parbhoo.
Why should you save your money?
According to John Manyike, head of financial education at Old Mutual, saving offers the following benefits.
- It helps you handle financial shocks – for instance, the effects of the pandemic on jobs and income.
- It helps you to avoid taking on debt, thereby avoiding costly interest payments.
- It helps you cover unforeseen emergency expenses.
- From a psychological point of view, it can reduce anxiety, and give you peace of mind and a sense of control.
- It helps you develop self-discipline and budget responsibly. This makes it easier to take the next step and start investing money.
- It can allow you to pool funds in, for example, a stokvel or burial society, providing you with added motivation to remain committed to your goals.
Are you ready to start your savings journey?
Thami Cele, head of savings and investments for Absa Retail and Business Bank, offers the following tips to help you start saving.
- Watch the interest rates on fixed deposits. The rates that you see today might not be the same when you lock up your money tomorrow. But once the money is locked up, the rates will remain the same throughout the term of your savings.
- Set goals. You need to know the purpose of your saving. If you don’t, it will be easier for you to spend the money. When you have a goal, you tend to be more disciplined than when you don’t.
- Decide how much you want to save and set a target. Any amount that you have is sufficient, and you will avoid stretching yourself beyond your limits.
- Determine whether you’re saving to receive interest, or to make saving your lifestyle. Research shows that people who have a savings buffer tend to be more productive, giving, happier, and structured in their investment ventures.
- Include saving in your budget. You need to be intentional about it and not only save leftover funds.
- Take advantage of tax-free savings accounts. These enable you to save for long-term goals and your returns will not be subject to tax.