It pays to understand how interest works

In South Africa, nominal interest rates and effective interest rates are commonly used terms that can apply to the cost of borrowing and the rate of returns earned when investing.

The nominal rate of interest is the stated or simple rate, which ignores the impact of compounding (interest on interest). The effective rate shows the effect of compounding. Typically, financial institutions will quote you a nominal rate when you borrow money (because it understates the true cost of credit) and an effective rate when you invest money.

Before you take out a loan, always ask for the effective rate of interest as well as the total cost of credit to determine what the loan will effectively cost you.

The National Credit Act (NCA) prescribes the maximum interest rates but doesn’t stipulate whether the rate is nominal or effective. The Act does, however, stipulate how interest must be calculated and provides a formula that applies to calculating interest on short-term credit transactions (microloans) and a formula to calculate interest on any other credit agreement.

The NCA states that interest may be calculated daily and may be added to the “deferred amount” monthly, at the end of the month.

Annemarie Friedman, senior legal adviser at the National Credit Regulator (NCR), says the deferred amount is the total amount of credit granted and includes the obligation deferred – for example the loan amount, the initiation fee, service fee, interest, credit insurance, default administration charges and collection costs.

“Interest is calculated on the deferred amount, and the deferred amount includes interest,” Friedman says.

For any credit agreement other than a short-term credit transaction, the rand amount of interest for any particular day must be calculated as follows:

Deferred amount for the day multiplied by interest rate divided by number of days in the year.

Personal Finance asked credit providers, the credit industry body, the Credit Ombud and the NCR if the interest rates set out in the NCA are nominal or effective.

* Eloise Biggs, head of communications for African Bank, said the rate is neither nominal nor effective. “We apply an annualised rate – it is a simple per annum rate based on the outstanding balance.”

* Charl Nel, head of strategic communications, marketing and corporate affairs at Capitec Bank, said: “The rate and formula prescribed by law is: nominal annual compounded monthly.”

* Magauta Mphahlele, chief executive officer of the National Debt and Mediation Association, an organisation funded by the credit provider industry, said: “Section 40 of the regulations suggests that it is an effective interest rate that is calculated daily and added monthly to the deferred amount.”

* Manie van Schalkwyk, the Credit Ombud, said: “According to us it is a nominal rate.”

* Stephen Logan, an attorney who specialises in the NCA, said: “There is no reference in the regulations whatsoever to compounding. All interest rates are nominal. Compounding is not factored into the quoted rate. That said, in the pre-agreement quotation the total cost of credit, which includes the effect of compounding, should be stated.”

* The NCR’s Rajeen Devpruth said: “There is no mention of effective or nominal rate but interest must be calculated in the prescribed manner.”

To illustrate how interest is calculated, Capitec provided an example (see “Repayments on a personal loan”) where interest is calculated and capitalised monthly on the 26th of the month on the highest interest rates that the bank charges.

Nel says the formula for calculating interest is the outstanding balance multiplied by number of days divided by 365 multiplied by the interest rate divided by 100.

Brett Cameron, an actuary at Old Mutual, explains the complexity in calculating and comparing interest rates.

“Nominal rates don’t include the impact of compound interest, or interest on interest, and therefore would understate the annual effective compound rate. Nominal rates of interest can be simple to use in calculations, but they aren’t very intuitive and may also be difficult to compare.”

To illustrate his point, he gives the following example of R1 000 invested over a year at various nominal rates, showing that actual interest earned “isn’t quite what you would expect it to be”.

* A nominal annualised interest rate of 10 percent applied monthly would give you R104.71 in total interest earned;

* A nominal annualised interest rate of 30 percent applied monthly would give you R344.89 in total interest earned; and

* A nominal annualised interest rate of 60 percent applied monthly would give you R795.86 in total interest earned.

“A consumer who thinks they are paying nominal interest of 60 percent for a short-term loan may be paying an annual effective rate of interest of as much as 79.5 percent.”

Cameron says it would be more helpful for consumers if banks and credit providers were required to quote you an annualised effective rate of compound interest because this is more in line with one’s intuitive understanding of the cost of interest.

Example of repayments on a personal loan