In the next two or three posts I am going to write about some basic definitions which are applicable to all investments.


Nominal Interest Rate: This is the interest rate that is quoted without taking into account the effects of compounding (number of times the interest is calculated in a year).


Effective Interest Rate: This is the interest rate that is quoted after taking into account the effects of compounding.


Let’s say you have an initial investment of 100 dollars and it compounds monthly at 1% per month. The nominal interest rate in this example is 12% per annum (1% * 12 months). But the effective interest rate is a bit different. The effective rate takes into consideration the effects of compounding.

At the end of 1st month your initial investment becomes $101 ([100 *.01]+100).
At the end of 2nd month your initial investment becomes $102.01 ([101 *.01]+101).
so on and so forth….

So the difference here is the interest you earned on your initial investment is also earning interest (effect of compounding). The formula for converting nominal to interest rates is (1+ i/n)^n (i = nominal interest rate; n= number of periods the compounding happens). In the above example i=12% and n=12 (monthly compounding means its compounded 12 times in a year). Based on the above formula your effective interest rate for this example is 12.68%.

Another example: Lets say your credit card charges 2% per month. Your nominal interest rate is 24% (2 * 12 months). Your effective interest rate (the actual rate you get charged) is 26.82%. So you see - its very important to understand the difference between the two rates. With the effective interest rate you will be charged interest on interest accumulated. And this is the interest rate that you should focus on because your payments on this card is based on this rate.

Summary:

• Effective Interest Rates takes into consideration the effects of compounding.
• The Nominal Interest Rates does not take into consideration the effects of compounding.
• Due to the effects of compounding the effective interest rates is usually higher than the nominal interest rates.

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Topics: Financial Definitions |

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