The interest rates you are quoted by your bank are not always what they appear to be. More often than not they are more than one percentage point a year higher than you expect.
The reason is the difference between nominal rates and effective rates.
Banks are keen to tell you about effective rates when you lend them money but only about nominal rates when you borrow money from them.
Nominal rates are based on the interest rate for a year. If you borrow R100 and are charged 12 percent a year, you would pay R12 in interest.
With an effective rate you are charged the interest on periods shorter than the year, for example monthly or quarterly. What the banks do is divide, for example 12 percent, by, for example the number months in the year, charging you one percent a month. They add the one percent a month to the money you owe them so you pay interest on interest in subsequent months.
When you deposit money in a bank, you can also gain from an effective rate because if your interest is paid monthly, or quarterly, and it is compounded (or added to your capital).
Chris Bvsenberg, an actuarial consult at Sanlam Employee Benefits says while it is not illegal for banks to quote you the nominal rate instead of the effective rate, it is misleading.
Where most people are affected by this are with mortgage bonds and bank overdrafts.
A Personal Finance reader said he thought he had achieved great things when he negotiated 19 percent interest rate on a R150 000 home loan. But when he got home, he calculated that the actual rate he would be charged was 20,75 percent - almost 1,75 percent more.
"If you negotiate an 18 percent interest rate, you think is not that onerous, but 18 percent is not what the financial institutions say it is," Bvsenberg says. "Your 18 percent actually works out to 19,56 percent ... so banks should be saying they are giving you an effective rate of 19,56 percent."
This would give the public a more accurate idea of what they will be spending on housing, which more than likely makes up the single biggest expense in a family's monthly budget.
Andrew Birrell, a Cape Town actuary, says in Britain the Consumer Credit Act of 1974 stipulates that people must be given the actual cost of credit, whether it be for bond, motor vehicle or any other type of financing.
Stuart Grobler, general manager of the Council for South African Banks (Cosab) - the banking industry's umbrella body - says there is no similar law in South Africa.
Most banks work out interest on a daily balance and capitalise it monthly and they should tell you, he says.
Financial institutions make comparisons difficult by using nominal rates, says Bosenberg.
He said that if for example, the return of a particular investment was 20 percent a year and you were weighing up whether to pay off your bond or invest, you should realise that by paying off your bond you can indirectly earn an after-tax return of 20,75 percent if the quoted nominal rate is 19 percent
"It is far more attractive to pay off your bond under these circumstances," he says.
How to save on your bond
You can reduce the term of your loan by five, ten or even 12 years by paying a relatively small additional monthly amount, Patrick Maingard, Cape regional manager of NBS.
Maingard says on a typical R160 000 bond at an interest rate of 20 percent a year, the repayments will be R2 674 over 30 years.
By paying a mere R11 a month more, the bond term will decrease by five years.
It will cost you only R44 more a month on your repayments if you have taken the bond over 20 years.
"This means over the 20-year period, a borrower can, at today's rate, save more than R300 000 in interest and repayments compared to the 30-year period," he says.
An alternative approach is to increase your bond repayment at the same rate as your annual salary increase.
Calculating effective interest rates
To illustrate the compound effect, let's assume you invest R100 at the bank at 18 percent interest a year. A nominal rate of 18 percent converted monthly is equal to 1,5 percent a month (18 divided by 12). If you invested at this rate, an amount of R100 would become R101,50 after one month (R100 x 0,015).
At the end of the second month, it would be R103,02 (R101,50 x 1.015) and so on. After 12 months, it becomes R19,56. This means you would have earned 19,56 percent in interest - and not 18 percent on your R100 investment.
The same principle applies when you borrow money from the bank, when for example you take out a housing loan, except of course then you are the one who is paying the interest.
To calculate the effective interest rate that you are being charged on your bond, you can use the following formula:
effective+ 1 = (1 + nominal rate) payment frequency
ratepayment frequency
Note: Payment frequency = number of times payment is required, for example 12 in the case of monthly payments, four for quarterly payments, two for half-yearly payments.
So, if you borrowed R100 000 from the bank at a nominal interest rate of 19,25 percent, the calculation to determine the effective rate (ER) would be:
ER + 1 = (1 + 0,1925)12
12
=(1 + 0,016)12
=(1,016)12
=1,2098
ER=1,2098 - 1
=0.2098
ER percentage = 0.2098 x 100
=20,98 %