Posting Point
The interest rate offered by a bank is a key factor influencing a customer’s choice in selecting one savings account over another. Customers can grow their savings considerably by understanding how savings account interest rates work and their different types.
Banks and financial institutions distinguish two categories of savings account interest rates – nominal and effective. While nominal rates are calculated on the principal amount, the effective interest rate considers compound interest on the principal and accumulated interest.
What is nominal interest rate and how is it calculated?
Also called the ‘stated’ or ‘quoted’ interest rate, a nominal savings account interest rate represents the simple interest paid on a deposit over a specified period. This is the interest rate that the bank offers you at the beginning of your savings journey. Here is how you can calculate the nominal interest rate of a savings account:
Nominal interest rate = (Simple interest/Principal amount)*100
If you deposit ₹15,000 in a savings account offering an annual nominal interest rate of 5%, it means that by the end of the year, you will earn a simple interest of ₹750.
What is effective interest rate and how is it calculated?
The effective interest rate reflects the actual rate you earn after considering how often the interest is compounded within the year. For instance, if the nominal rate is compounded quarterly, the effective interest rate will be slightly higher than the nominal rate due to the effect of compounding.
Here is the formula for calculating the effective interest rate on a savings account:
Effective interest rate = [1 + (Nominal interest rate/n]]^n – 1
The effective interest rate on a savings account accrues on the principal amount and the accumulated interest from previous periods of deposit. If you consider the same savings account as above with a nominal interest rate of 5%, with quarterly compounding frequency, the effective interest rate will be 5.11% and the interest earned will be ₹787.18.
Nominal vs effective interest rates: A comparison
Here are the key differences between nominal and effective interest rates for savings accounts –
Effective vs nominal rate of interest
Feature
Effective rate of interest
Nominal rate of interest
Calculation
Calculated based on the principal amount.
Calculated based on the principal amount and the accumulated interest.
Real returns
Provides a more accurate picture of the real return.
Does not account for the compounding effect, therefore does not reflect real returns.
Compounding frequency
Compounded monthly, quarterly, annually, etc.
Remains constant
Relevance for decision making
Helps you calculate annual returns.
Does not help you calculate annual returns.
Which interest rate should you consider while evaluating a bank’s savings account?
To get a better understanding of how much you can save using a particular savings account, you must consider its effective interest rate. In addition to this, you must also analyse if the bank offers key features, such as the smart-sweep feature.
The IndusInd Bank Indus Max Multiplier Savings Account offers the smart-sweep feature that automatically transfers any balance that exceeds ₹20,000 into fixed deposits in multiples ₹1,000. This helps maximise your savings by allowing you to earn higher interest on your idle funds.
To sum up
You can get a better understanding of your overall annual savings by understanding the effective interest rate on your savings account. This type of savings account interest rate is calculated on the principal amount and the accumulated interest rate.
Now that you have understood this key concept, why wait? Open a bank account online today and maximise the growth potential of your savings!
