When it comes to savings accounts, mentions of the nominal rate can lead to some confusion. This is because some calculations distinguish between nominal and real interest rates to come up with exactly how much your savings will be worth.
The nominal rate is simply the rate that financial institutions will advertise to you. For example, if your deposit of $100 earns $5 in interest during the year, then your nominal rate is effectively 5 percent.
However, financial institutions may not always include fees and charges into this calculation, so if you incurred $2 in fees for your savings account, your nominal rate is still 5 percent, despite you only earning 3 percent ($3) from your savings.
The tricky part is when the real interest rate is brought in. This is the rate that tells you how much “buying power” your savings really have, after inflation. For example, on your $100 of savings, if your nominal rate was 6 percent and inflation for the year was 3 percent, then the real interest rate is calculated as the difference (6 minus 3), meaning that your money only increases in value by 3 percent during the year.
So logically and unfortunately, when your savings account is earning below inflation, your money is just sitting around and losing value.
Your nominal rate is used to calculate how much your savings will grow throughout the years, as it will be difficult to predict inflation and fees in the future. For example, if your savings account provides 5 percent in interest, then $2,000 in 5 years’ time will become $2,552.56.
In essence, your nominal rate is the “raw” rate you get, and everything else such as costs, inflation, and tax can be deducted from it to calculate more “realistic” rates for your money.
Try some of these calculations yourself to understand what you’re really gaining from a savings account. After you get the hang of things, make sure to do a quick comparison of some of today’s highest interest rates on savings accounts to get more bang out of your buck and beat the drag of inflation.