Interest Rates – Nominal & Effective

Nov 29, 2022 | General Financial Planning News, News, Newsletter Articles

Portia Vlotman, Associate Director and Money Market Manager, discusses rising interest rates and explains the difference between nominal and effective rates.

The South African Reserve Bank raised its benchmark repo rate by another 75 bps to 7.00% at its November 2022 meeting, as was widely expected. This was the seventh consecutive hike since November 2021 and may not be the last in this cycle.

In a rising interest rate environment, it is not advisable to fix funds for lengthy periods to capture the upside. However, when the cycle peaks or declines, fix funds as long as possible to capture the higher rate.

All rates of interest are annualised in their calculation and are generally quoted as a per annum return.

A client can either opt for a nominal rate (this being a monthly interest payment), which is an uncompounded return, or an effective rate (interest paid at date of maturity) ‒ this is a compounded rate of interest.

An illustration of the difference in nominal and effective rates is shown below:

R100,000 invested at 7.90% = R670.95 (with interest paid out monthly) times 12 months = R8,051.50

R100,000 at an effective rate at 8.10% (with interest paid at the end of the term) = R8,100.00.

The effective annual rate is therefore higher than the nominal rate.

The South African Revenue Service requires account holders to pay tax on interest earned on Money Market accounts and other types of interest-paying deposit accounts.

The interest exemptions from a South African source, earned by a natural person under 65 is R23,800 per annum and for persons 65 years and older, up to R34,500 per annum.