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What are Nominal and Effective Interest Rates in Savings Accounts
Posted on Tuesday, February 20th, 2024 | By IndusInd Bank
Welcome to the realm of savings accounts, where your money has the potential to grow through the magic of interest rates. Understanding the various types of savings accounts interest rates is crucial for making informed financial decisions. So, buckle up as we explore nominal vs effective interest rates.
Let’s start with the basics – the nominal interest rate. This is the straightforward rate that financial institutions proudly present to you. The effective interest rate in savings accounts refers to the total interest earned on an account over a specified period, taking into account compounding.
What is a Nominal Interest Rate
Think of the nominal interest rate as the upfront promise made by the bank. It’s the stated annual interest rate you see when you open a savings account. It’s like the starting point for your savings adventure.
Let’s say your savings account has a nominal interest rate of 3%. This means that for every Rs.100 you have in your account, the bank promises to give you Rs. 3 in interest over the course of a year. It’s that simple. The nominal interest rate is like the foundation of a building – it sets the stage for what’s to come. Understanding the nominal interest rate matters because it helps you compare different savings accounts and make intelligent financial decisions.
What is an Effective Interest Rate
While nominal interest rates are a helpful starting point, they only tell part of the story. They don’t consider how often the interest is added to your account, which brings us to the effective interest rate. It gives you a more accurate picture of your money’s actual growth or cost.
Here’s how it works. When you deposit funds into your savings account, the bank pays you interest not only on your initial deposit but also on the interest you have already earned over time.
It’s like a snowball effect – your money accumulates more, and compounding is the engine behind this snowball.
Consider this example: If you have a savings account with a nominal interest rate of 10%, the effective rate will vary depending on how often the interest is calculated, as shown below:
| Frequency of interest rate compounded | Effective rate |
| Daily compounding | 10.52% |
| Monthly compounding | 10.47% |
| Yearly compounding | 10.25% |
The nominal interest rate, the rate banks flaunt, is like the tip of the iceberg. The effective interest rate goes beneath the surface, considering how often your interest compounds, and tells you exactly how much you’ll end up with and dives deep into the potential of your savings.
Real Interest Rate
After understanding the effective vs nominal rate of interest, let’s take a quick understanding of ‘real interest’, a less commonly used term compared to other interest rates, and it signifies the interest rate post accounting for . For an investment to be deemed worthwhile, your effective interest rate must surpass the inflation rate, ensuring that the real interest rate stays positive. The real rate provides insight into the actual growth of your investment in real terms, considering the impact of inflation, which gradually erodes its purchasing power over time.
Summarising Different Interest Rates
So, if you’re comparing investment options, looking at the effective rate is wise to get an accurate picture of your earnings. The real interest rate considers inflation, helping you assess whether your investment is growing in purchasing power.
In simple terms, nominal is what’s stated, effective is what you get, and real takes inflation into account, providing a clearer understanding of how your money is working for you over time. With this knowledge about different savings account interest rates, you’re now equipped to make savvy decisions and watch your money grow like never before. Happy saving!
Disclaimer: The information provided in this article is generic in nature and for informational purposes only. It is not a substitute for specific advice in your own circumstances. Hence, you are advised to consult your financial advisor before making any financial decision. IndusInd Bank Limited (IBL) does not influence the views of the author in any way. IBL and the author shall not be responsible for any direct/indirect loss or liability incurred by the reader for taking any financial decisions based on the contents and information.
