Understanding your interest rate

You may have seen an advert for a five-year fixed deposit offering an interest rate of 13.3% on maturity. This seems like a really high interest rate, but what you need to understand is that this is the interest you receive at the end of a five-year period. It is not the annual interest rate that is paid.

The simple interest rate, paid on maturity or expiry, includes interest you have earned on your interest by leaving it to be re-invested – allowing for a compounding effect. This means it is driven as much by the length of time you are invested, as by the interest rate paid by the bank. This rate on maturity is only valid if you leave your money fully invested, including all interest earned, for the full five years.

In this particular advert by African Bank, the fine print reads that the interest rate is actually 10.75% per annum, which is equivalent to 13.33% per annum calculated on expiry after 60 months.

If the annual interest rate, compounded annually, is 10.75%, that means in one year a R100 000 investment would pay R10 750 in interest. But if you re-invest that interest, the balance grows to R110 750 and the 10.75% interest is applied to this new, higher balance. This results in more interest being earned in the second year of R11 905. If you re-invest that amount it grows the balance, and you earn 10.75% on a larger amount, and so on.

If you invest R100 000 and leave it untouched for five years, you would receive about R66 616 in interest at the end of the fifth year. By dividing that total rand interest earned by five, you get about R13 323 a year, or an average return of 13.32% per annum.

While the annual compounded rate of 10.75% is still a good interest rate ‒ in fact, it’s currently the best rate offered over five years ‒ it is not the same as the one grabbing the headline of the advert.

An annual compounded rate, also known as an annual effective or equivalent rate, is the interest rate paid each year.  Things get even more complicated when comparing interest rates because interest rates are stated as either “effective” or “nominal”. As interest is actually paid monthly, there is a compounding effect even within a year.

“Nominal” means the annual rate before the effect of monthly compounding, while “effective” is the interest rate when taking monthly compounding into effect. So, for example, on a short period of one year, you may see something like: “7.7% nominal and 7.97% effective”.

This means that the bank pays the interest monthly (7.7% divided by 12 months) so that each month the interest earns interest which means over a year, your effective rate would be 7.97%.

For investment periods of less than a year, the bank will still show the nominal annual interest rate as if you were invested for the full year for comparative reasons, but your interest received would only be for the months you were invested – in other words 7.7% divided by 12 months and multiplied by the number of months you are invested. For six months that would be 3.85% (7.7%/12 x 6 months).

The best way to compare rates is to compare the nominal interest rate, as that doesn’t take the length of time invested into account. In fact, if you calculate the nominal rate on the African Bank advert, it works out to around 10.3%. You can then decide if that 10.3% is worth locking in for five years when you compare it to other banks’ nominal rates.

Ideally you should ask the bank for a quote showing you the actual rand interest you will have received over the period of time for which you want to invest.

This article first appeared in City Press.

13 CommentsLeave a comment

  • If I have a Fixed Deposit of R500,000 for 60 months, monthly income and pass away after 40 months, will my Capital be guafanteed for the full payout?
    I asked this question to ABSA, aswer NO!
    I asked this question to Capitec, no response on my e-mail.
    Investec, yes, capital is guaranteed.

    • Great question. Your question I assume is whether you will get the advertised rate on maturity – your original capital would always be guaranteed. I think this would be bank dependent and I would suspect that they will only pay the interest up to the period that the money is with them. But interesting that Investec said they would.

  • This is great what is currently some of the best investments to make. Reason for my question I started investing around R5k per month in a nedbank fix deposit a few years back and earned interest of about 6-7% per annum the current balances per month is nearing 30k per month and now I want to move it around. Please help with advice

  • Hi.

    I always thought Nedbank green saving bond offers the best, but then i came across Fedgroup which indicate effective rate of 11.3% and the one of African bank.

    So comparing all of this, does it mean African bank is offering the best?

    Because the other fine prints on their advert is that the rate offered at the time of investment will not be lowered/reduced due to interest rate cut if i am not mistaken.

    • Ask for the annual effective rate or the nominal rate – that will be the best way to compare. Make sure you are comparing the same type of rate. If Fedgroup’s effective annual rate is 11.3% then that would compare to African Bank’s effective annual rate of 10.75%. So you can see how important it is to make sure you are comparing like with like. Good to read the fine print but most fixed rates are exactly that – fixed irrespective of interest rate changes

      • This is the reply from Fedgroup. So yes, the African Bank rate is higher:

        Nominal Rate – 9%
        Annual compound rate – 9.38%
        Effective interest on maturity – 11.31%

        By way of illustration, if an investor chose to invest the minimum R5000 and withdraw all interest monthly, they’d get R37.50 a month over 5 years (R5000 X9% /12) and their full R5000 capital back at the end of the term.

        If they reinvested all interest they’d receive R7828.41 back at the end of the 5 years. (a gross return of 56.57% over the full term /5 = 11.31% effective annual return)

  • Thanks for that.

    I was just looking into it and this explains a lot. ABSA also quoted a 13% for 5 years a while ago but you had to be over 60.
    Just to say , I love your show on E TV . I wish more people would take your advice and get out of debt.

  • After what happened with African Bank a few years ago, is it save to invest with African Bank? What about Finbond who also advertise an interest rate of 11.5%

    • Great question. Rates usually indicate the level of risk which is why African Bank would have to offer a higher rate than a mainstream bank to get the deposits. One hopes that African Bank learnt its lesson on the lending side, but what we did see with the crisis was that smaller investors were bailed out by government, so that does provide some sense of security.
      Finbond is not somewhere I would put my money having seen their lending practices. They have not always behaved ethically. African Bank is a substantially larger organisation.

  • I am made to understand that overseas interest rates are far lower than San,s, sometimes as low as 3% pa. Given this scenario does it not make easy money to borrow funds from overseas & invest them locally?

    • Excellent question. South Africa’s high interest rates are what keep foreign investment flows alive! Without those we would struggle to have enough foreign currency to settle our trade imports. This is concept is lost in the economic debate of whether or not we should cut interest rates.
      In terms of borrowing to invest – there are several challenges. Firstly you have currency risk. So if you owed 3% in USD’s but the rand weakened by 10%, that repayment effectively increases by 10%.
      Secondly you have to be able to borrow overseas. Unless you have assets or a track record with an excellent credit record and foreign income to pay the loan – it is unlikely anyone would lend you the money

Leave a Reply

Your email address will not be published. Required fields are marked *

Join the Maya on Money weekly newsletter

Join the Maya on Money weekly newsletter

For updates that impact your day-to-day money decisions.

You have Successfully subscribed. Please check your inbox to verify your subscription.