What does it exactly mean when we say that a bank fixed deposit, or say any investment, gives 10% interest?
It means that if I invest Rs.1000 in this scheme, I will get an interest income of Rs.100 after one year.
Now suppose there is another scheme, which also offers 10% interest... with only one small difference... it pays out interest after every 3 months. In other words, I now get Rs.25 after every 3 months. So in a year, I again receive a total interest income of Rs.100.
Even though I earn same money from both schemes, 2nd scheme is naturally a better one. Why?
Because I can reinvest the Rs.25 I receive after 3 months and earn interest on it for the remaining 9 months of the year. (Similarly I earn extra interest on the Rs.25 I receive after 6 months and 9 months, for 6 months and 3 months respectively.) So, "effectively" I can earn more than Rs.100 in one year.
How much is this extra income?
In Microsoft excel there is a formula to calculate the effective interest rate when there are more than one interest payouts in a year, i.e.
= EFFECT(nominal_rate, npery)
where nominal_rate is the nominal interest rate (i.e. 10% in the above example)
and npery is no. of interest payments per year (i.e. 4 in the above example)
So for the 2nd scheme the effective interest rate is
= EFFECT(10%, 4)
= 10.38%.
Thus, in the 1st scheme our interest income is 10% and in the 2nd scheme 10.38%. Hence, after one year we can effectively earn Rs.103.80 in the 2nd scheme vis-a-vis Rs.100 in the 1st scheme.
Therefore, it stands to reason that to make a meaningful comparison between different investment opportunities or loan offers, we must convert the varied representations of the interest rates into the effective interest rate... i.e. interest receivable / payable after one year.
In fact, many banks and companies often resort to interest rate jugglery to present a rosy picture. The idea is to fool you into believing that you are getting an excellent deal. This happens in both instances namely
a) when you invest, you are shown that you will earn much HIGHER interest rate than others
b) when you borrow, you are shown that you will pay much LOWER interest rate than others
Clearly, you must look into the fine print and compute the right rate that you will actually earn (or the right cost that you would actually incur.)
Remember, you can't accept any offer at the face value.
It means that if I invest Rs.1000 in this scheme, I will get an interest income of Rs.100 after one year.
Now suppose there is another scheme, which also offers 10% interest... with only one small difference... it pays out interest after every 3 months. In other words, I now get Rs.25 after every 3 months. So in a year, I again receive a total interest income of Rs.100.
Even though I earn same money from both schemes, 2nd scheme is naturally a better one. Why?
Because I can reinvest the Rs.25 I receive after 3 months and earn interest on it for the remaining 9 months of the year. (Similarly I earn extra interest on the Rs.25 I receive after 6 months and 9 months, for 6 months and 3 months respectively.) So, "effectively" I can earn more than Rs.100 in one year.
How much is this extra income?
In Microsoft excel there is a formula to calculate the effective interest rate when there are more than one interest payouts in a year, i.e.
= EFFECT(nominal_rate, npery)
where nominal_rate is the nominal interest rate (i.e. 10% in the above example)
and npery is no. of interest payments per year (i.e. 4 in the above example)
So for the 2nd scheme the effective interest rate is
= EFFECT(10%, 4)
= 10.38%.
Thus, in the 1st scheme our interest income is 10% and in the 2nd scheme 10.38%. Hence, after one year we can effectively earn Rs.103.80 in the 2nd scheme vis-a-vis Rs.100 in the 1st scheme.
Therefore, it stands to reason that to make a meaningful comparison between different investment opportunities or loan offers, we must convert the varied representations of the interest rates into the effective interest rate... i.e. interest receivable / payable after one year.
In fact, many banks and companies often resort to interest rate jugglery to present a rosy picture. The idea is to fool you into believing that you are getting an excellent deal. This happens in both instances namely
a) when you invest, you are shown that you will earn much HIGHER interest rate than others
b) when you borrow, you are shown that you will pay much LOWER interest rate than others
Clearly, you must look into the fine print and compute the right rate that you will actually earn (or the right cost that you would actually incur.)
Remember, you can't accept any offer at the face value.
