Understanding the different interest-rate types and why it matters

We hear them so often: nominal interest rates, real interest rate, add-on interest rates, effective interest rates, compound interest rates – each having its own meaning and implications for borrowers, lenders and investors. Understanding them is critical to meaningful financial decision-making.

Borrowers, savers and investors must know the different types of interest rates because the figures they see and hear do not necessarily tell the true cost of money or how much it earns. Knowing and understanding the different types of interest rates help in comparing the cost of borrowing from various lenders, as well as comparing the returns on various instruments and the returns on the same types of instruments being offered by different competitors for the funds of consumers.

So, interest rates must be front and centre in any decision relating to personal loans, student loans, credit cards, mortgages, savings accounts, deposit accounts, money market instruments, bonds and debentures.

Here are some common types of interest rates.

The nominal interest rate is the quoted or stated rate of interest, but it may not tell the borrower the full cost of borrowing nor the saver the full rate of return, as it may not reflect compounding. With compounding, other types of interest rates exceed the nominal rate.

The nominal rate is not as comprehensive as the annual percentage rate, which is the annualised cost of borrowing money, expressed as a percentage and includes interest and certain mandatory fees.

The nominal rate is seen in another sense: in relation to inflation. It is the rate before taking account of inflation. The real rate is the rate after adjusting for inflation, but it is not a rate that appears in any document.

Add-on interest is calculated on the original principal – not on the reducing balance – for the full term, even though the principal decreases as the borrower makes contractual periodic payments. By way of example, interest on a loan of J$1,000,000 for five years at a rate of 10 per cent is calculated as follows: J$1,000,000 x .10 x 5 = J$500,000, which is added to the J$1,000,000, and the J$1,500,000 is repaid over 60 months in equal instalments, though there could be other associated charges. This makes the loan cost more than the stated rate suggests. In other words, add-on interest makes the effective rate higher than the stated rate.

The effective rate is the actual annual cost or yield after taking compounding into consideration. This is generally the most useful rate to use when making comparisons, as it allows for fair comparison among products.

Compound interest is ‘interest upon interest’, which increases the cost of debt as interest is added to arrears, resulting sometimes in delinquent borrowers owing more than they borrowed. On the other hand, interest earned on interest increases the returns to savers. As compounding may be done more than one time during the year, the more frequent the compounding, the better the return, just as borrowing costs increase due to compounding.

In investments, the rate of interest on the bond or other interest-bearing security generally determines the yield, or rate of return. There are cases, however, in which investors buy medium- to long-term bonds and debentures below or above their face value. In such cases, the capital gain makes the yield higher or the capital loss makes it lower than the stated interest rate.

Consumers need to read the fine print when saving and investing their funds, and when borrowing, and must compare interest with interest before making a decision to borrow or to place funds.

Borrowers should consider not just the rate of interest charged on loan funds and how interest is calculated, but on the charges and other loan conditions, as these may reduce or eliminate any advantage which they may seem likely to gain from lower lending rates.

Investors in interest-bearing securities should note that the stated rate of interest is an annual rate, meaning that the interest is for a full year. Savers and investors should not expect to get a full year’s interest for funds they save or invest in interest-bearing securities for less than a full year – an expectation which some people do have based on experiences I had as a stockbroker, and on an experience an investment adviser shared with me recently.

Nominal interest rates do not tell the full story, so it is unwise to base financial decisions solely on them. Knowing the effective interest rate, particularly in the cases of add-on and compound interest rates on loans, and on savings and interest-earning financial instruments, should be at the forefront of such decisions.

Oran A Hall, author of Understanding Investments and principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel. Email: finviser.jm@gmail.com.