Nominal vs Effective Interest Rates

Five nights a week, I am up to my thank-you-90’s-over-plucked eyebrows in Financial Planning textbooks, and I’m going to be brutally honest about something:

The Finance Industry is complicated. The people running this sh!t have made it difficult to understand. And they have done it on purpose. Case in point? Here’s my calculator. Tell me this doesn’t look like something belonging to NASA, and capable of sending more unwilling animals into space:

DO NOT use this as an excuse to throw in the towel, shrug, and say “Why even bother?”

Here’s why:

You do not need to know everything. You do not need a degree in Economics. You do not need to understand every term, technique and type of investment out there. A lot of the bamboozling stuff doesn’t even apply to you.

But there are a couple of critical things you do need to know, because not knowing them can cost you. I’m going to call the difference between Nominal and Effective Interest Rates one of the Tricks of the Trade, because it certainly can be used to trick the unsuspecting person into paying much more than they bargained for.

In my previous lesson on Compound Interest, I explained how compounding can be, for an investor, like pumping your money full of steroids and watching it grow to gargantuan proportions. Unfortunately, when you’re in debt, that compounding is what causes things to spiral out of control. When it comes to interest rates, knowing what you’re getting into is about as important as remembering to feed your children.

Now this is where Nominal and Effective interest rates come in.

A nominal rate is where interest is compounded once a year.

Easy example – you owe Ryan Reynolds R1000. Turns out he’s pretty decent in real life, though a little avaricious, and he’s going to charge 12% interest but you only have to pay him back in a year.

12% of R1000 is R120. After a year, you’ll owe Ry-Ry R1120. The interest was compounded (calculated) only once at the end of the year, so it’s a nominal rate. You guys are all square, and if you’re lucky, he’ll invite you to dinner with Blake sometime. You guyzzzzzzzzzzah!

But look what would have happened had you borrowed the money from your dodgy Uncle Francis…

Maybe you were desperate. No judgment here. He also quoted you the 12% interest rate on R1000. And he also told you he only needs to be paid back in a year. Maybe he isn’t so bad after all? Maybe he didn’t really tell everyone that dreadful joke comparing your mom to a bowling ball, that is too revolting to repeat, even in a place as filthy as the Internet. Maybe the family can be reunited at last! Merry Christmas everyone!!!!

Hang on. Nope:

What dear old Uncle Frank didn’t mention was that he was compounding the amount you owe every three months. In finance-speak, that means on a quarterly basis. In this case, you’d need to take the 12% and divide that by 4, which gives you 3%. You’re going to pay 3% interest on the money you owe, every three months.

After the first 3 months, you owe Franky-boy R1030. After the next 3 months, you owe Unks R1060.90. Three more months go by and now you Frank the Tank R1 092.72. By the end of the year, and the end of the last 3 months, you owe Francis J Underwood R1 125.50.

Now if you had to sit down and work out how much interest you were actually charged to get to that number after a year, it turns out that you actually paid a 12.55% interest rate. And that “true” interest rate is called the Effective interest rate.

Whether it’s money you’ve invested, or money you owe, how often your money is compounded makes a BIG difference. Sure in the example above, the difference was only R5.50, but that was because we used small simple numbers and a short time frame.

Here’s a super-sh!t sandwich you don’t want to take a bite out of: the interest on money you owe on a loan is usually compounded DAILY. In a situation like that, the difference between the nominal rate you’d pay back in a year, and the effective rate you ACTUALLY end up paying back is going to be big. And a big difference, means lots more money.

The bottom line to help grow your bottom line?

Always find out how often your money will be compounded. If someone quotes you an interest rate, always ask if that’s the Nominal Interest Rate, or the Effective Interest Rate.

Happy Women’s Day to all the fierce financial females out there!

– The Money Mom

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