July 2006

How the rates hike helps your savings grow

When you're in debt, an interest rate hike is bad news, but if you are debt-free, and you have savings, an increased interest rate would be good news for you.

In the June issue of Money Matters we considered the impact that the interest rate increase has on holders of debt, particularly homeowners with mortgages. Now we need to look at how wonderful it is for debt-free savers when the interest rate goes up – and also at how important it is to understand exactly what interest you really earn.

Let's say you receive a year-end bonus of R3800. Imagine a scenario in which you've paid off your bond, your car, your store cards etc, and you have no outstanding debt.

You don't need to use that R3800 to pay off any debt, so you can put it straight into a savings account. You scan comparison charts in the newspaper's finance section and decide that a savings account at bank X pays the best rate of interest – 6,25%. But before you jump in, find out whether that quoted rate is nominal or effective. What's the difference?

Nominal rates are normally quoted, irrespective of the frequency of interest payments. For example, nominal interest of 6,25% on R3800 would amount to R237,50 if interest is payable once a year.

Effective rates should be quoted when interest is paid to you more than once a year, such as every six months. For example, your R3800 invested at 6,25% p.a. would earn you R118,75 interest at the end of six months, i.e. 3,125% of R3800 where the interest is paid (capitalised) every six months. Add R118,75 to R3800 and you get R3918,75. For the next six months you will earn 3,125% on R3918,75, which is R122,46 – in total R3,71 more than if you had earned nominal interest of R237,50. Your effective interest rate is actually R6,35%.

Obviously, you need to establish what the effective rate of interest is so as to determine which savings account offers the best return. Furthermore, some banks quote you a nominal rate when you borrow money from them. This can be misleading, so find out exactly what rate they are offering. For example, a nominal mortgage bond rate of 11% really means an effective rate of 11,57% if bond instalments are made on a monthly basis and the interest is also calculated on a monthly basis.

But back to the lending rate hike - if the repo rate increase in June of 50 basis points (half a percentage point, or 0,5%) caused the interest rate on savings accounts to increase by the same margin, the effective interest on your savings account, using the example above, would have gone from 6,35% to 6,85% (nominally, from 6,25% to 6,75%).

This is the wonder of savings. That interest is money you didn't have to go out and earn by working. Even more wonderful is the miracle of compound interest. The effective interest rate incorporates the effect of compounding. The power of compounding can best be illustrated by way of an example:

If you save R300 per month from the age of 25 to the age 35 at an effective rate of return of 7% per annum and then leave the accumulated savings amount to earn further interest up to age 55, the accumulated final sum would amount to R199 698. However, if you only started saving at the age of 35 and continued to save R300 per month up to age 55 (i.e. for 20 years instead of 10), your final accumulated savings would amount to only R153 122 even though you saved for 10 years longer.

However, it is not always the best option to save your discretionary money. There truly is little point in saving that R3800, if you do have debt on which you pay a higher interest rate than that which you can earn by saving the money.

If the interest rate on your mortgage bond is, say, 11% per year compounded monthly, it means that you will effectively "earn" a tax-free return of 11,57% per annum on the R3800 if it were used to repay some of the mortgage debt. It goes without saying that it is normally far better to repay your debt before you start to save. 

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