Don’t Be Fooled By Nominal Interest Rates….

By FutureNestEgg | August 31, 2009

The interest rates that banks advertise for their savings accounts usually does not take into account the effect of compounding. These rates are nominal interest rates. Comparing two different accounts based on the advertised interest rates alone is not a true a comparison of the two accounts. You need to compare the effective interest rates of the two accounts.

Let me explain this in more detail and in plain English – Let’s say you have two accounts – Account A offers 6% p.a. and Account B offers 5.5% p.a.

To begin with, both these advertised rates are nominal interest rates. So if you were to pick an account based on interest rates alone, then you would naturally pick Account A. This is the mistake most people make. Don’t be fooled by nominal interest rates…Read the fine print.

The effective interest rate takes into account the effects of compounding while the nominal interest rates does not.

Find out how many times the interest is calculated and also how often interest it is credited.

Let’s say Account A and Account B are both calculating interest every day – Okay, now you may assume it is definitely Account A because both are calculating interest daily but Account A has a higher interest rate – and so you might think it is obvious choice.

But wait – there is one more important thing you need to find out – Find out how often it is credited – Let’s say Account A credits interest once a year and Account B credits interest every month. This frequency of crediting interest changes everything. When you are crediting daily, then you are earning interest on interest. Your account balance increases every time interest is credited and from the following day, you will start earning more interest. This is what is called ‘effects of compounding‘.

Effective Interest Rate takes into account the effects of compounding and is the real interest rate – considers the frequency of interest rate crediting.

This true comparison of interest rate is especially important when you are trying to compare term deposits with other savings accounts – term deposits usually advertise rates which are higher than online savings accounts, but their interest amounts are usually credited at maturity (even though sometimes they are calculated daily). For online savings accounts, the frequency of crediting is usually higher than for term deposit accounts.

Click here to use my Effective Annual Interest Rate Calculator.

Any thoughts, any good examples of interest rate comparisons, please share below

Best,