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If you have excess cash in your business that you don’t need immediate access to, it’s a good idea to earn interest on it on a longer term product that offers a higher return. The exact cash investment product you choose would depend on the specific cash flow needs your business has. While there’s no shortage of choice in the South African market for these kinds of cash investment products, the problem is that as a consumer, comparing them can be difficult. But why is this, and what can you do about it?
The main challenge with comparing cash investments is that you may be quoted a different kind of interest rate on the same product from different providers. One offering, for example, may advertise a nominal interest rate, while another may refer to an annual effective rate or even a yield rate. These different interest rates all vary in terms of the period over which earned interest is calculated – which means you’re not comparing like with like.
For this reason, it’s crucial to be clear on what you’re actually being quoted, so you can work out the actual returns you’ll get on your capital investment. With this in mind, here are the three main types of interest rates associated with a cash investment product, and how they relate to each other.
Nominal Rate (NACM)
The nominal interest rate is the interest that is earned assuming you stayed invested in the product for an entire year but you withdrew the interest every month. If you want to determine the interest earned for a particular month, you would need to take the NACM rate, divide it by 365 and then multiply it by the number of days in that month. NACM also means that you don’t benefit from compounding interest, because interest is drawn out monthly.
For example, let’s assume you have R100 000 to invest. If you’re quoted a nominal rate of 6.75%, your return would be calculated as follows:
Annual Effective Rate (NACA)
This is the rate of interest earned over a one year period, assuming that all interest earned monthly is reinvested into the deposit on a monthly basis. This rate therefore takes into account compound interest, in that you’re earning interest on top of the previous month’s investment that includes the previous month’s interest too. An annual effective rate assumes that the capital amount grows each month, so your investment will be compounded over the year.
Effective Rate (EFF)
Like an annual effective rate, the effective rate refers to the rate of interest earned over the entire cash investment period, assuming that all interest earned monthly is compounded to the capital balance. The difference, though, is that an effective interest rate does not have to be for an entire year’s term – it can be three or six months, depending on the product being offered. In the case of a three month investment, for example, the effective rate calculates the compound effect for the three months only.
To calculate the actual compounded interest you would earn, take the effective rate, divide it by 365 and then multiply that answer to the actual number of days for the product in question.
The yield rate refers to the to earnings that are generated on an investment over a particular period of time, expressed as a percentage based on the overall investment amount. So, with a five year fixed deposit account, for example, instead of quoting a nominal or annual rate, you’ll be quoted a yield rate that assumes you’ll compound your interest for the full 60 months. For this reason, yield rates are usually given as large numbers – which is understandably attractive to consumers. But if you unpack this and work out the annual or nominal rate you’ll get on the same investment, the actual numbers look very different.
No matter which type of cash product you’re considering investing in, it’s important to be savvy as a business consumer and know exactly what kind of interest rate you’re being quoted. While this is always included in the fine print or terms and conditions, they’re easy to miss. If you’re unsure, ask the provider what your balance would be on the end date were you to invest all of your money on day one. Once you know how much capital you would have gained, you can work backwards and compare it accurately with other seemingly similar short term investment products.