Interest Rates: Nominal meets Real meets Effective


different types of interest rates explained

Updated: 12th October 2018

As we have already seen inflation can be a tricky monster. It gets even worse when it comes to savings – yes, the inflation monster is affecting your savings; and not in a good way.

When looking at interest there is a nominal interest rate and a real interest rate. And then, there is also the effective interest rate, at which we will have a closer look at.

Nominal Interest Rate vs Real Interest Rate

The “nominal interest rate” is the rate banks offer you for depositing money in one of their savings accounts.

The “real interest rate” is the rate you are effectively getting if you plan to buy goods and services with money you have put in your savings account. The real interest rate is determined by subtracting the inflation rate from the nominal interest rate.

Real interest rate = Nominal interest rate – inflation rate

If a bank offers you 5% interest on your savings and the current inflation is about 3.8%, your real interest rate would be 1.2%. The following example shall illustrate what is going on:

Savings Year 0: RM1,000Amount Spend Year 0: RM1,000
Interest Rate: 5%Inflation Rate: 3.8%
Savings Year 1: RM1,050Amount Spend Year 1: RM1,038

Total earnings after the first year: RM12; instead of RM50. The result is, inflation took away almost 80% of your earnings.

However, if you have a loan, inflation can be a good thing, as displayed in the following example:

Loan Year 0: RM1,000Loan Year 1: RM1,000
Interest Rate: 5%/Inflation Rate: 0%Interest Rate: 5%/Inflation Rate: 10%
Interest Payment: RM50

This applies under the assumption, that your salary increases by the inflation rate (in this case here: 10%) as well

Theoretical Interest Payment: -RM50

 

The result is, that theoretically, your interest payment is negative, which means that your increase in salary is higher than the interest payment you have to make for your loan.

It can even get worse if the inflation is higher than your savings, which would lead to a loss of money, even though you think, you are saving money.

Handling Nominal and Real Interest Rates

Nominal and Real Interest Rates

Cross-check your investments on a regular basis and evaluate your potential earnings on interest rates with the current inflation. Are you still on top of inflation? If yes, perfect; if not, consider the following advice:

  • Always keep an open eye for new offers from banks in terms of deposits and other investment opportunities. If there is a better option, you should try to opt out for the better. You will be able to earn extra money.
  • Try to invest your money for more than one year, as a longer savings period would allow you to take advantage of the compounding effect of interest rates, you can read more in this article. The power compounding interest is a mighty effect that is able to beat inflation by far. Especially in the long run.
  • If you notice that some products you regularly buy increase in terms of prices on a regular basis, try to find other products which are more stable in prices. You might be able to diminish the inflation effect as you are switching to products that are not as affected as others.
  • Maximize your earnings through savings by diversifying your options. Consider the stock market as the return rates are higher in the long run. However, keep in mind to never invest money that you need into the stock market. The stock markets can move up and down a lot, and you should always be able to “sit out” the fluctuations, therefore you need to leave your money in your stock investments for a period of time.

We have put together 3 of the most rewarding savings accounts which can be seen in the table below.

The Top 3 Savings Accounts

OCBC 360 AccountUp to 4.1% per year for up to RM100,000
UOB eAccount3.08% per year for deposit amount above RM20,000
Affinbank Esaver-i2.3% per year for deposit amount above RM50,00

The effective interest rate

Lastly, there is the effective interest rate, which helps you to find out the true yearly interest rate if a bank is only showing you monthly interest rate numbers. It is calculated as Stated interest rate divided by the number of compounding periods to the power of years of investment. Simply said, the effective interest rate reflects the yearly interest rate you have to pay for a loan.

(Stated interest rate / Number of periods)^Investment time

This gets clearer with an example: If a bank offers you 5% interest per 6 months and pays you your interest twice a year, then an investor who invests RM1,000 will earn RM25 after half a year (1000 x 5% / 2) and RM25.63 after another half year.

The investor earned a total of RM50.63 while the nominal interest rate was 5% and would only generate RM50. The effective interest rate was 5.1%. When looking at savings, this is a very positive effect for you and if you see an offer that includes interest payments more often than annually, you should always consider having a closer look.

With regard to loans:

At first glance, a monthly interest rate of 1% might add up to 12% on a yearly basis. Unfortunately, this assumption does not include the monthly compounding effect. In fact, the interest rate is 12.1%, calculated as (1%/12)^12.

On CompareHero.my we always display the effective interest rate, as it enables you to compare all the different loans via only looking at one standardized number.

Always try to be on top of all the information that is offered

The main advantage of knowing all these differences is that it allows you to make better decisions about your investments and loans. Now that you are equipped with this knowledge you can efficiently use our free comparison tool to check all the features of personal loans.

compare personal loans and save thousands of ringgit

 

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