Terminology
The effect of compounding depends on the frequency with which interest is compounded and the periodic interest rate which is applied. Therefore, in order to define accurately the amount to be paid under a legal contract with interest, the frequency of compounding (yearly, half-yearly, quarterly, monthly, daily, etc.) and the interest rate must be specified. Different conventions may be used from country to country, but in finance and economics the following usages are common:
Periodic rate: the interest that is charged (and subsequently compounded) for each period, divided by the amount of the principal. The periodic rate is used primarily for calculations, and is rarely used for comparison. The nominal annual rate or nominal interest rate is defined as the periodic rate multiplied by the number of compounding periods per year. For example, a monthly rate of 1% is equivalent to an annual nominal interest of 12%.
Effective annual rate: this reflects the effective rate as if annual compounding were applied: in other words it is the total accumulated interest that would be payable up to the end of one year, divided by the principal.
Economists generally prefer to use effective annual rates to allow for comparability. In finance and commerce, the nominal annual rate may however be the one quoted instead. When quoted together with the compounding frequency, a loan with a given nominal annual rate is fully specified (the effect of interest for a given loan scenario can be precisely determined), but the nominal rate cannot be directly compared with loans that have a different compounding frequency.
Loans and finance may have other "non-interest" charges, and the terms above do not attempt to capture these differences. Other terms such as annual percentage rate and annual percentage yield may have specific legal definitions and may or may not be comparable, depending on the jurisdiction.
The use of the terms above (and other similar terms) may be inconsistent, and vary according to local custom or marketing demands, for simplicity or for other reasons.
Read more about this topic: Compound Interest