Market-leading interest rates may sound appealing at face value but are you sure you are always comparing apples with apples?
As service providers it is our responsibility to ensure that as far as possible any published information is as clear, fair and reasonable as possible, says Neil Thompson, Head of Product at African Bank.
Generally, providers advertise the Annual Compounding interest rate – that’s the interest you earn as a depositor if you leave your deposit with the bank for a full year and only draw the interest at the end of that year.
National Treasury has also advocated this in the hope of simplifying the calculation for consumers and allowing ease of comparability between products. However, not all providers do this as transparently as consumers would like, and unfortunately it is easy to make the common mistake of comparing compounded interest rate, also referred to as a “Expiry Rate”, with a simple non-compounding rate if this is not spelt out clearly.
To illustrate the point consider the following example, where African Bank currently offers a 10.5% rate for a fixed term deposit of 5 years. That’s the Annual Compounding rate that the customer earns if he or she elects to have interest paid out annually. Simply put if you were to invest R100 000 in this 5-year fixed term product on 1 July 2018, African Bank would pay you R10 500 in interest on 30 June 2019, and again on 30 June 2020, 30 June 2021, and 30 June 2022, and return the principle together with the 5th year’s interest on 30 June 2023 paying out a total of R 110 500 on that date.
Let’s now look at what is termed the “Expiry Rate”. This is a higher rate that is earned by not having African Bank pay you the interest on an annual basis but by having the interest paid out on maturity of the product after 5 years. At first you may think it is simply 5 x R10 500, or R 52 500 paid out, which together with the return of the original principal would result in a total pay-out of R152 500 on 30 June 2023.
That is, however, not the case, and the reason for this is compounding or earning interest on interest. When we don’t have our interest paid out by the bank it is effectively re-invested and earns interest again at this Annual Compounding rate. Under this scenario the customer earns an additional amount of over R12 000 resulting in total interest earned of over R64 000 at an “Expiry rate” of 12.95%.
So how does this happen? Let’s illustrate this by using the same example
By compounding or earning interest on interest the customer earns more in total over the term of the deposit than they would do by having the interest paid out to them at the end of every year.
For example, looking at the numbers in the table below Year 2, the customer earns interest at 10.5% on R110 500, earning interest of R11 603. They are effectively earning 10.5% on R100 000 and the R10 500 interest earned in the first year that is reinvested. That soon adds up over the 5- year period and the customer then earns a total of R64 745 versus R52,500. That’s the power of compounding or earning interest on interest.
Now let’s get to the interest rate point. In the last line you will see rate of 12.95%, this is what we term the annual “Expiry Rate”. It is calculated by dividing the total interest earned (R64 745), by the principal (R100 000) by the number of years (5), to give you 12.95%. While it looks a lot higher it is merely achieved by not drawing down on the interest each year and reinvesting it at 10.5%. That’s the power of compounding and saving.
Let’s say, however, that you cannot wait for 5 years, or even an annual pay-out, and need to be paid out monthly as you need the interest eared to meet monthly expenses. You may think that it merely a case of dividing the annual pay out by 12 and getting that amount monthly, that is receiving R10 500/12 = R875 monthly. As with the example above that’s not the case. What we need to determine here is what annual rate when compounded monthly gives you an equivalent Annual Compounding rate of 10.5%. By now it should be clear that the rate will be less than 10.5%, in the same way that the Annual Compounding rate is less than the Expiry Rate in the example above.
The Monthly Compounding rate that is equivalent to an Annual Compounding rate of 10.5% is 10.03%.
Each month you would earn 10.03% /12 of the amount invested. If the interest is capitalised to the investment amount each month, you would earn 10.03%/12 of the original investment amount, plus the interest already earned, which is the effect of compounding. The continuing monthly compounding of the 10.03% then equates to 10.5%, in the same way that the 10.5% Annual Compounding rate equates to an annual Expiry rate of 12.95% in the interest is reinvested annually.
You would be paid out an average amount of R835 33 each month, being R100,000 x 10.03%/12. Note that the amount is calculated by reference to the number of days so the amount in February with 28 days would be less, while the amount in January with 31 days would be more
Thompson says what is important to remember is that in all three cases the same Annual Compounding rate of 10.5% was used but the effective rate was different based on compounding impact of interest earned and not paid out under the Expiry rate scenario, and paid out under the monthly interest rate scenario. “Clearly it is better to leave your interest in the bank and let it accumulate for as long as possible to receive the greatest return.”
“It is therefore always important to ensure you compare the same effective rate when making comparisons across banks. If you want your interest monthly, you need to ensure you compare monthly rates vs monthly rates at other banks. If you want the full impact of compounding ensure you are comparing the same Expiry Rates, also sometime referred to as maturity rates, for the same maturities, across all banks.
Remember to shop around and make the necessary comparisons. Don’t be afraid to ask questions and make sure you understand what interest you will be earning. You may find at the end of the day you could be comparing apples with oranges,” concludes Thompson.