This is how your interest rate is calculated

Economists expect that the South African Reserve Bank will cut the repo rate on Thursday, giving South Africans a little more breathing room when it comes to their finances. But do you understand what this means for your wallet and how the actions you take could save or cost you?

Consumers will say everybody keeps telling them to save and save more, but the language of money and saving can be confusing. All that jargon in the terms and conditions does not always inspire trust and confidence, which can explain why the merits of saving can get lost in the noise of money leaving your bank account, Cheslyn Jacobs, chief commercial officer at TymeBank, says.

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We asked him to explain the key terms of saving to help consumers understand what the numbers mean to make informed decisions regarding their hard-earned money:

What are interest rates?

An interest rate is a percentage charged or paid on the total amount you borrow or save, Jacobs says. If you borrow money, the interest rate will increase the total amount that you owe, but if you save or invest your money in an account that offers interest, the interest rate is the amount that your savings will earn over the investment period, increasing your total savings balance.

“Therefore, the longer you leave your money in the bank, the more interest you will earn.”

What is the prime interest rate?

The prime interest rate is linked to what the South African Reserve Bank (Sarb) has determined as the prevailing rate, also called the repo rate. If your savings are in an account based on the prime interest rate, the rate will fluctuate according to what the Sarb determines as the current rate.

Jacobs says you can also fix your interest so that it is not affected by the movements in the markets or how the Sarb changes the interest rate. “As the name suggests, fixed deposit accounts give you this kind of certainty.”

This example shows how interest helps to grow your savings if you deposit R1 000 in a fixed deposit account that pays 10% interest per year. At the end of the year, you will earn a guaranteed R100 interest on your money, regardless of the changes in the prime interest rate. 

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What is compound interest and how does it affect savings?

Jacobs says compound interest can be described as ‘interest on interest’. “When banks refer to an effective interest rate (as opposed to a nominal rate), they are referring to a rate that takes the compounding effect into account.”

For example, he says, if you deposit R1 000 in your account and leave it there for one year, your money will grow to R1 100, just as it would in the first example. “If you kept the same amount in your savings account for a second year at the same rate, your money will now earn interest on R1 100 instead of the principal amount of R1 000. It will now grow to R1 210.

As this example illustrates, the longer you leave your money invested, the more money you make, which is why fixed deposit accounts are so popular for medium to long-term savings. However, Jacobs warns that you must be disciplined to make it work.

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What is the difference between a nominal and an effective interest rate?

A nominal interest rate is in place when the interest from your fixed deposit account is paid out every month and not reinvested, Jacobs says. An effective interest rate is when you earn interest on the interest that is reinvested and it takes the effect of compounding into account. It is the rate that reflects the actual interest you earn on an investment.

What is the best advice you ever received about saving?

“Firstly, always ask your bank about what the interest is on each saving option and check if it is aligned to your financial goals,” says Jacobs.

Based on his own personal experience, Jacobs says the best advice he got when he started working was to be disciplined when it comes to saving.

“Paying yourself first by putting some money aside every month, no matter how small the amount and watching it grow over time, will be infinitely rewarding – whether interest rates drop or rise. And if you put that money into an appropriate savings product, it will grow even faster.”