Nominal and
Effective Interest
Rates
Interest Rate Statements
The terms ‘nominal’ and ‘effective’ enter into consideration when the interest
period is less than one year.
Interest period (t) – period of time over which interest is
expressed. For example, 1% per month.
Compounding period (CP) – Shortest time unit over which interest
is charged or earned. For example,10% per year compounded
monthly.
Compounding frequency (m) – Number of times compounding
occurs within the interest period t. For example, at i = 10% per
year, compounded monthly, interest would be compounded 12
times during the one year interest period.
Understanding Interest Rate Terminology
A nominal interest rate (r) is obtained by multiplying an interest rate that is
expressed over a short time period by the number of compounding periods in a longer
time period: That is:
r = interest rate per period x number of compounding periods
Example: If i = 1% per month, nominal rate per year is
r = (1)(12) = 12% per year)
Effective interest rates (i) take compounding into account (effective rates can be
obtained from nominal rates via a formula to be discussed later).
IMPORTANT: Nominal interest rates are essentially simple interest rates. Therefore,
they can never be used in interest formulas.
Effective rates must always be used hereafter in all interest formulas.
More About Interest Rate Terminology
There are 3 general ways to express interest rates as shown below
Sample Interest Rate Statements Comment
i = 2% per month When no compounding period
(1)
i = 12% per year is given, rate is effective
i = 10% per year, comp’d semiannually When compounding period is given
(2)
i = 3% per quarter, comp’d monthly and it is not the same as interest
period, it is nominal
i = effective 9.4%/year, comp’d semiannually When compounding period is given
(3) and rate is specified as effective,
i = effective 4% per quarter, comp’d monthly
rate is effective over stated period
Effective Annual Interest Rates
Nominal rates are converted into effective annual rates via the equation:
ia = (1 + i)m – 1
where ia = effective annual interest rate
i = effective rate for one compounding period
m = number times interest is compounded per year
Example: For a nominal interest rate of 12% per year, determine the nominal and
effective rates per year for (a) quarterly, and (b) monthly compounding
Solution: (a) Nominal r / year = 12% per year
Nominal r / quarter = 12/4 = 3.0% per quarter
Effective i / year = (1 + 0.03)4 – 1 = 12.55% per year
(b) Nominal r /month = 12/12 = 1.0% per year
Effective i / year = (1 + 0.01)12 – 1 = 12.68% per year
Effective Interest Rates
Nominal rates can be converted into effective rates
for any time period via the following equation:
i = (1 + r / m)m – 1
where i = effective interest rate for any time period
r = nominal rate for same time period as i
m = no. of times interest is comp’d in period specified for i
Example: For an interest rate of 1.2% per month, determine the nominal
and effective rates (a) per quarter, and (b) per year
Solution: (a) Nominal r / quarter = (1.2)(3) = 3.6% per quarter
Effective i / quarter = (1 + 0.036/3)3 – 1 = 3.64% per quarter
(b) Nominal i /year = (1.2)(12) = 14.4% per year
Effective i / year = (1 + 0.144 / 12)12 – 1 = 15.39% per year
