Nominal Versus Effective Interest Rate
The nominal interest rate is the periodic interest rate times the number of periods per year. For example, a nominal annual interest rate of 12% based on monthly compounding means a 1% interest rate per month (compounded). A nominal interest rate for compounding periods less than a year is always lower than the equivalent rate with annual compounding (this immediately follows from elementary algebraic manipulations of the formula for compound interest). Note that a nominal rate without the compounding frequency is not fully defined: for any interest rate, the effective interest rate cannot be specified without knowing the compounding frequency and the rate. Although some conventions are used where the compounding frequency is understood, consumers in particular may fail to understand the importance of knowing the effective rate.
Nominal interest rates are not comparable unless their compounding periods are the same; effective interest rates correct for this by "converting" nominal rates into annual compound interest. In many cases, depending on local regulations, interest rates as quoted by lenders and in advertisements are based on nominal, not effective interest rates, and hence may understate the interest rate compared to the equivalent effective annual rate.
The term should not be confused with simple interest (as opposed to compound interest) which is not compounded.
The effective interest rate is always calculated as if compounded annually. The effective rate is calculated in the following way, where r is the effective rate, i the nominal rate (as a decimal, e.g. 12% = 0.12), and n the number of compounding periods per year (for example, 12 for monthly compounding):
Read more about this topic: Nominal Interest Rate
Famous quotes containing the words nominal, effective, interest and/or rate:
“Discourage litigation. Persuade your neighbors to compromise whenever you can. Point out to them how the nominal winner is often a real loser—in fees, expenses, and waste of time. As a peacemaker the lawyer has a superior opportunity of being a good man. There will still be business enough.”
—Abraham Lincoln (1809–1865)
“I know no method to secure the repeal of bad or obnoxious laws so effective as their stringent execution.”
—Ulysses S. Grant (1822–1885)
“History in the making is a very uncertain thing. It might be better to wait till the South American republic has got through with its twenty-fifth revolution before reading much about it. When it is over, some one whose business it is, will be sure to give you in a digested form all that it concerns you to know, and save you trouble, confusion, and time. If you will follow this plan, you will be surprised to find how new and fresh your interest in what you read will become.”
—Anna C. Brackett (1836–1911)
“As a novelist, I cannot occupy myself with “characters,” or at any rate central ones, who lack panache, in one or another sense, who would be incapable of a major action or a major passion, or who have not a touch of the ambiguity, the ultimate unaccountability, the enlarging mistiness of persons “in history.” History, as more austerely I now know it, is not romantic. But I am.”
—Elizabeth Bowen (1899–1973)