Want to know how much you’re really earning on your savings? You need to work out the real interest rate

Julie Brownlee, Fsp Invest, 09 Sep. 2014

Tags: real interest rate, what is a real interest rate, inflation, nominal interest rates, how to calculate real interest rate

If you have money in the bank, the interest rate the bank pays you should be important to you.

You want to try to get the best interest rate you can.

To do this, you need to work out the ‘real’ interest rate.

So what is the real interest rate? And how can you calculate the real interest rate of your savings account?

Read on to find out…

What is a real interest rate?

In the world of finance, a ‘real’ figure is one that takes inflation into account. On the other hand, a ‘nominal’ figure doesn’t.

So a real interest rate is an interest rate that takes into account the current rate of inflation.

It’s worth working this out, which you can do easily. When banks and other financial institutions quote interest rates, they tend to use the nominal rate.

By calculating the real interest rate, you can weigh up whether the interest rate you receive is keeping up with inflation (the rising cost of living).

How to calculate the real interest rate

Let’s look at an example…

You have R1,000 in a savings account. The bank pays you an annual interest rate of 8%.

By the end of year one, you’ll have R1,080 in your savings account.

Yet, if during the same year, the rate of inflation is 6%, a basket of goods that cost you R1,000 a year ago will now cost R1,060. In other words, the R1,000 won’t buy you as much as it did a year ago.

The real interest rate takes into account this fall in your spending power.

In our example, you’d have R20 left over (R1,080 – R1,060). That means the real interest rate is 2% (R20/R1,000).

The easy way to calculate the real interest rate is to take the nominal rate and subtract the rate of inflation from that. In our example this is 2% (8%-6%).

At the moment, consumer inflation is sitting at 6.3%. So if you managed to put your money into a savings account with a nominal interest rate of 8%, your real interest rate would be 1.7%.

If the interest rate you receive is less than 6.3%, it means you’re losing money as inflation eats into your savings.

So there you have it, how to work out the real interest rate to find out how much you’re really earnings on your savings.

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