Nominal and Effective Savings Interest – Is There any Practical Difference?
Savings interest is not a complicated phenomenon. It is the percentage that is paid out on savings per year. The bank gives a fee for making the money available. After all, the bank can make a lot of money by lending that money, they charge interest on loans that is much higher than the interest on savings. The terms ‘nominal interest’ and ‘effective interest’ sometimes raise questions. They are usually the same in savings accounts. Sometimes there is a difference. This is due to the number of times interest is paid in a year.
Interest Calculation per day with Nominal Interest
The interest that the bank pays is calculated per day. The computer uses the balance and interest rate to calculate the amount of the interest amount for that day. The interest rate used to calculate is the nominal interest rate. These interest amounts added together result in an interest payment. This is credited to the savings account at the end of the interest period.
Nominal Interest Rate
With the nominal interest rate, the interest payment per day is calculated on the balance in your savings account.
Interest-on-Interest = Compound Interest
Most savings accounts pay interest once a year. Then the nominal savings interest is equal to the effective savings interest. A difference only arises when interest bookings are made several times a year, for example per quarter. The saver will then receive interest after the first quarter, nicely calculated according to the number of days that the savings have been in the account. This credit increases the balance of the savings account. And if nothing is included and the interest rate remains the same, a little more interest will be added after the second quarter. We call this the interest-on-interest effect, or compound interest.
The result per year is Effective Interest
If we look at the end of the year to see what percentage of interest has been reimbursed in total, with multiple interest payments per year it is more than the nominal percentage on the balance, because of that interest-on-interest effect. The result is the effective savings rate.
Nominal Interest Example:
On January 1, Mr. David deposits an amount of $10,000 into a savings account with a nominal interest rate of 2%. The savings account pays interest once a year. Exactly one year later, he receives interest: an amount of $ 200 (2% x $ 10,000).
Example Effective Interest:
On the same date, Mr. Marco also deposits $ 10,000 into a savings account with a nominal interest rate of 2%. This savings account pays interest once a quarter. After the first quarter, he will receive an amount of $ 50 in interest (simplified, calculated with 3/12, so not exactly with daily interest). The balance is then $ 10,050. After the second quarter, the interest addition is $ 50.25 (2% x $ 10,050 – divided by 4). The third quarter generates $ 50.50 and the fourth quarter $ 50.75. In total, Marco received $ 201.50 in interest after a full year. The nominal interest rate of 2% comes to an effective savings rate of 2.015%.
For two accounts with the same nominal interest rate, payment per quarter therefore gives you a better (effective) return than payment per year.
Comparing savings accounts
Comparing savings accounts should therefore not revolve around the nominal interest rate. Choosing a savings account is about what you actually receive in return, the effective savings interest. That should therefore be leading in your choice for a savings account.
Determine savings interest
How is the savings interest determined?
If you hold a savings account, it is nice if you also receive a substantial compensation from the bank for this: the savings interest. On this page we discuss how the level of the savings interest is determined.
Adjustment of variable savings interest
Many savers have a variable interest savings account. The interest can therefore be changed by the bank at any time. Up or down, you don’t know that in advance. What is interesting for the saver is how that savings interest is then determined.
Variable savings interest
Variable means that something is not fixed. This also applies to your variable savings interest. The bank can increase or decrease it at any time.
Random from the bank
Most banks have no way of drawing up what they do with the interest on savings. There is no way of determining which is shared with the customers. In fact, you are completely at the mercy of the bank. The background to the level of the savings interest is usually in:
Developments in the financial markets
Interest at European level has a clear influence on interest rates in the Netherlands.
If for any reason a savings bank wants to attract a lot of savings, an increase in the interest rate will help. Conversely, very low savings rates also show that a bank is not really waiting for savings.
The largest Dutch banks in particular often pay low savings rates. They can do this because many savers apparently do not switch to another savings bank.
Link to Euribor
The clearest way of determining the variable savings rate is if there is a fixed link with general interest rates, such as the Euribor. Then you, as a saver, know that there is no arbitrariness, that your interest is determined objectively by the bank.
Communication of changes in savings interest
If the variable savings rate is changed, a bank must of course tell its customers. One savings bank does this more clearly than the other. One thinks that a fine print entry on a bank statement is sufficient, while the other sends an email to all its savings customers.