While interest rate cuts are good news for some and bad for others, especially pensioners, understanding the nature of interest rates and their influence may help you manage your finances more effectively, says Capitec Bank’s Executive of Marketing and Corporate Affairs, Carl Fischer.

Here, he gives iafrica.com the lowdown…

What are interest rates?

Interest rates are closely tied to the economy of a particular country and can profoundly affect its residents. The interest rate is the price a borrower has to pay to enjoy the use of cash that he or she does not own. It is also the return that a lender, such as the provider of a credit card, mortgage or personal loan, enjoys for lending the money. The interest rate is usually expressed as a percentage of the total amount loaned and is determined by market forces (supply and demand).

How do interest rates affect the consumer?

In times of rising interest rates, credit providers adjust their rates accordingly. If you have borrowed money, rising interest rates mean you will need to pay more on home loans and other loans. If on the other hand you’ve invested money then you’ll stand to gain more on your investment.

Nominal interest rates

When people discuss interest rates, such as those that impact deposits and loans, they're generally talking about nominal interest rates. These are used to calculate repayments on almost all debt. Nominal interest rates are defined by the fact that they are unaffected (unadjusted) by inflation.

Effective interest rates

Also known as real interest rates, the effective interest rate is linked to an inflation index. Depending on the rate of inflation or the frequency of compounding, an effective interest rate is the actual interest — where inflation has been accounted for — paid on a loan or earned on a deposit account. To calculate the real interest rate you’ll need to know the inflation rate (or expected inflation rate if you’re making a prediction about the future).

An example to illustrate interest rates

Suppose you invest R100 in a savings account for one-year that pays six percent at the end of the year. You pay R100 into your savings account at the beginning of the year and get R106 at the end of the year. The savings account therefore pays an interest rate of six percent. This six percent is the nominal interest rate, as inflation has not been accounted for.

Now, suppose the inflation rate is three percent for that year. You can buy a basket of goods today and it will cost R100 or you can buy that same basket next year and it will cost R103. If you invest R100 in a savings account with a six percent nominal interest rate, take your money out after a year and get R106 back and then buy a basket of goods for R103, you will have R3 left over.

So, after factoring in inflation, our R100 investment will earn you R3 in income; a real interest rate of three percent. The relationship between the nominal interest rate, inflation and the real interest rate is contained in the following equation: Real (or effective) Interest Rate = Nominal Interest Rate – Inflation

For further information about Capitec Bank, click here!

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