Ch4: Understanding Money & It's

Management

INDE 6365 Engineering Economy II

Ch4: Nominal & Effective Interest Rates

By: Magdy Akladios, PhD, PE, CSP, CPE, CSHM

Nominal and Effective Interest Rates

Example
$100 loan at a rate of 6% semiannually (12% annually,
compounded semi-annually).
You pay $6 for the first six month
Now you owe $106, therefore, you pay $6.36
Your total payment at the end of the year is: $6 +
$6.36 = $12.36.
Therefore, the actual interest rate is 12.36% not 12%.
We call 12.36%, Effective Interest Rate
We call 12%, Nominal Interest Rate
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By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Nominal Interest Rate (r),

Also known as Annual Percentage Rate (APR)
For rates compounded more frequently than
one year, r is the stated annual interest rate.
Note that:
r is the nominal interest rate per compounding
period,
whereas, APR is the nominal interest rate per year.

Annual Percentage Rates (APR)

APR = Percentage rate per period (r) X number
of periods (M).
APR = r x M
Hence, Interest rate per period = APR/M
Where:
M = Number of compounding periods/year
r = Annual interest rate (APR)

Effective Interest Rate (i)

Also known as Annual Effective Yield-APY

APY truly represents the interest earned in a
year

By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Example of Nominal & Effective Int. Rates

Nominal Rate:
Compounding Semi-annually:
Compounding Quarterly:
Compounding Monthly:
Compounding Daily:

10.00%
10.25%
10.38%
10.47%
10.52%

Compounding more often than once/year

Single Amounts
In this case, you are given:
nominal interest rate, and
total number of compounding periods

P, F, or A can be determined by:

F = P (F/P, i%, n)

Where:
Effective interest rate (i%) = (1 + r/M)M 1
n = Number of years

Or, determine the total number of periods by

multiplying years and periods/year, then treat it as a
regular economic equivalency problem.
8

Calculating APY
For rates compounded more frequently than
one year, i is the actual amount of interest
paid:
i = (1 + r/M)M 1
Or, i = (F/P, r/M, M) 1
Where:
M = Number of compounding periods/year
r = Annual interest rate (APR)

By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Example
A credit card company charges an
interest rate of 1.375% per month on the
unpaid balance of all accounts.
What is the Nominal annual interest rate
(APR)?
What is the effective interest rate/year?

10

Solution:
APR = r X 12 months = 12 X 1.375 =
16.5% (APR)
i = (1+0.165/12)12-1
i = 0.1781, or 17.81% per year

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Example
For the previous example, what if interest
rate is being charged daily?

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By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Solution:
i = (1+0.165/365)365 - 1
i = 0.1793, or 17.93% per year

13

Example
Given:
r = 4.66%/year
ie = 4.77%
P = $100,000
N = 2.5 years

Required:
Interest periods (M)
The balance at the end of 2.5 years
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Solution:
i = (1 + r/M)M 1
0.0477 = (1+ 0.0466/M)M 1
Therefore, M = 365 (hence, daily
compounding)

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By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Solution
To get the balance at the end of 2.5 years:
F = P (1 + ie)N
F = $100,000 (1 + 0.0477)2.5
F = $112,355

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Equivalence Calculations using

Effective Interest Rates
Step 1: Identify the payment period (e.g.,
annual, quarter, month, week, etc)
Step 2: Identify the interest period (e.g.,
annually, quarterly, monthly, etc)
Step 3: Find the effective interest rate that
covers the PAYMENT PERIOD.
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Case I: When Payment Period is Equal

to Compounding Period
Step 1: Identify the number of compounding
periods (M) per year
Step 2: Compute the effective interest rate per
payment period (i)
i = r/M
Step 3: Determine the total number of payment
periods (N)
N = M (number of years)
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By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Example: Calculating Auto Loan

Payments
Given:
MSRP = $20,870
Discounts & Rebates = $2,443
Net sale price = $18,427
Down payment = $3,427
Dealers interest rate = 6.25% APR
Length of financing = 72 months
Find: the monthly payment (A)
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Solution:

Step 1: M = 12
Step 2: i = r/M = 6.25%/12 = 0.5208% per month
Step 3: N = (12)(6) = 72 months
Step 4: A = $15,000(A/P, 0.5208%,72) = $250.37
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Dollars Up in Smoke
What three levels of smokers who bought cigarettes
every day for 30 years at $7 a pack would have if
they had instead banked that money each week:

Note: Assume constant price per pack, the money banked weekly and an annual
interest rate of 5.5% compounded weekly.
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By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Sample Calculation: One Pack per Day

Step 1: Determine the effective interest rate per
payment period.
Payment period = weekly
5.5% interest compounded weekly
i = 5.5%/52 = 0.10577% per week
Step 2: Compute the equivalent value at 30 years from now.
Weekly deposit amount
A = $7 x 7 = $49 per week
Total number of deposit periods
N = (52 weeks/yr.)(30 years)
= 1,560 weeks
F = $49 (F/A, 0.10577%, 1560)
= $49 (3973.23308)
= $194,688.42
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Solution
Level of smoker Would have had
1 pack a day

$194,688

2 packs a day

$389,377

3 packs a day

$584,065

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Example
Suppose you drink a cup of Starbuck coffee
($3/cup) on the way to work every morning
for 30 years.
If you put the money in the bank for the same
period, how much would you have, assuming
your accounts earns a 5% interest
compounded Daily.
NOTE: Assume you drink a cup of coffee
every day including weekends.
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By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Solution
Payment period: Daily
Compounding period: Daily

5%
0 .0 1 3 7 % p e r d a y
365
N 30 365 10, 9 50 days
i

F $ 3 ( F / A , 0 .0 1 3 7 % ,1 0 9 5 0 )
$76, 246
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Case II: When Payment Periods Differ from

Compounding Periods
Step 1: Identify the following parameters
M = No. of compounding periods/yr
K = No. of payment periods/yr
C = No. of interest periods per payment period
Step 2: Compute the effective interest rate per payment
period
For discrete compounding

i [1 r / CK ] C 1

For continuous compounding

i er/K 1

Step 3: Find the total no. of payment periods

N = K (no. of years)
Step 4: Use i and N in the appropriate equivalence formula
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Compounding MORE often than

Payment period

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By: Dr. Magdy Akladios

Ch4: Understanding Money & It's

Management

Case 0: 8% compounded quarterly

Payment Period = Quarter
Interest Period = Quarterly
1st Q

2nd Q
1 interest period

3rd Q

4th Q

Given r = 8%,
K = 4 payments per year
C = 1 interest period per quarter
M = 4 interest periods per year

i [1 r / C K ] C 1
[1 0 . 0 8 / (1 ) ( 4 ) ] 1 1
2 . 0 0 0 % p e r q u a r te r
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Case 1: 8% compounded monthly

Payment Period = Quarter
Interest Period = Monthly
1st Q

2nd Q
3 interest periods

3rd Q

4th Q

Given r = 8%,
K = 4 payments per year
C = 3 interest periods per quarter
M = 12 interest periods per year

i [1 r / C K ] C 1
[1 0 . 0 8 / ( 3 ) ( 4 ) ] 3 1
2 . 0 1 3 % p e r q u a r te r
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Case 2: 8% compounded weekly

Payment Period = Quarter
Interest Period = Weekly
1st Q

2nd Q
13 interest periods

3rd Q

4th Q

Given r = 8%,
K = 4 payments per year
C = 13 interest periods per quarter
M = 52 interest periods per year

i [1 r / C K ] C 1
[1 0 . 0 8 / (1 3 ) ( 4 )]1 3 1
2 . 0 1 8 6 % p e r q u a rte r
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By: Dr. Magdy Akladios

10

Ch4: Understanding Money & It's

Management

Effective Interest Rate per Payment Period with

Continuous Compounding
C

1
i 1
CK
where CK = number of compounding periods
per year
continuous compounding => C

i lim 1
C
C K

e r

1/ K

1
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Case 3: 8% compounded continuously

Payment Period = Quarter
Interest Period = Continuously
1st Q

2nd Q
interest periods

3rd Q

4th Q

Given r = 8%,
K = 4 payments per year

i er /K 1
e 0.02 1
2 .0201 % per quarter
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Summary: Effective Interest Rates per Quarter at

Varying Compounding Frequencies

Case 0

Case 1

Case 2

Case 3

8% compounded 8% compounded 8% compounded 8% compounded

quarterly
monthly
weekly
continuously

Payments occur Payments occur Payments occur

quarterly
quarterly
quarterly

Payments occur
quarterly

2.000% per
quarter

2.0201% per
quarter

2.013% per
quarter

2.0186% per
quarter

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By: Dr. Magdy Akladios

11

Ch4: Understanding Money & It's

Management

Compounding more often than once/year

Uniform and/or Gradient Series
In this case, you are given:
nominal interest rate,
total number of compounding periods, and
existence of a cash flow at the end of each period

P, F or A may be determined by:

the formulas and tables for uniform annual series (A)
and uniform gradient series (G).
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Find A, given i, k and X

(A given F)
Use: A = X (A/F, i%, k)
Where:
i is the effective interest rate per interest period
k is the period at the end of which cash flow occurs
X is the uniform cash flow amount at the end of each
K period
A is the uniform cash flow amount at the end of each
compounding period

35

Find A, given i, k and X

(A given P)
Use: A = X (A/P, i%, k)
Where:
i is the effective interest rate per interest period
k is the period at the beginning of which cash
flow occurs
X is the uniform cash flow amount

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By: Dr. Magdy Akladios

12

Ch4: Understanding Money & It's

Management

Effective Interest rate per

compounding period
i = (1+r/M)K-1
Where:
i = Interest per K compounding period
r = Nominal interest rate/year
M = Number of compounding periods/year (ie,
number of months/year)
K = Number of periods/compounding period (ie,
number of months/quarter)
37

Effective Interest Rates/Payment

Period
i = (1 + r/M)C 1
i = (1 + r/CK)C 1
Where:
M = The number of interest periods/yr
C = The number of interest periods/payment period
K = The number of payment periods/yr
i = effective interest rate/compounding periods

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Example
Suppose that a $100 lump-sum amount is
invested for 10 years.
The nominal annual interest rate is 6%
(APR), compounded quarterly.
How much is it worth at the end of the 10th
year.

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By: Dr. Magdy Akladios

13

Ch4: Understanding Money & It's

Management

Solution
There are 4 compounding periods/year, or
a total of 4X10 = 40 periods.
The interest rate per interest period is 6%/4
= 1.5%.
F = P(F/P, 1.5%, 40) = $100(1.015)40 =
$100 X 1.814 = $181.40

40

An alternative solution:
Effective rate = (1+0.06/4)4 1 = 0.0614 =
6.14%
F = P(F/P, 6.14%, 10) = $100 X 1.0614)10
= $181.40

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Example
Suppose that you make quarterly deposits
in a savings account that earns 9%
interest compounded monthly.
Compute the effective interest rate/quarter

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By: Dr. Magdy Akladios

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Ch4: Understanding Money & It's

Management

Solution
Given:
r = 9%
C = 3 interest periods/quarter
K = 4 quarters/yr
M = 12 interest periods/yr

Required:
i/quarter
i = (1 + r/CK)C 1
i = (1 + 0.09/12)3 1 = 2.27%
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Note
For the previous example:
Monthly interest rate = 9%/12 = 0.75%/month
Quarterly interest rate = 2.27% (calculated)
Effective Annual interest rate = 9.38%
i = (1 + r/CK)C 1 = (1 + 0.0075)12 1

44

Example
Suppose you have a bank loan for $10,000
which is to be repaid in equal end-of-month
installments for 5 years
The nominal annual interest rate is 12% (APR),
compounded monthly.
What is the amount of each payment?

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By: Dr. Magdy Akladios

15

Ch4: Understanding Money & It's

Management

Solution:
The number of repayment installments =
5 X 12 = 60 payments.
Nominal interest rate/month = 12/12 = 1
Therefore, A = P(A/P, 1%, 60) = $10,000
(0.0222) = $222

46

Example
For the cash flow diagram shown below, find P
The Nominal annual interest rate is 15%,
compounded monthly.
Cash flows occur every Quarter

P
Qrtr = $1,000

End of year 1

End of year 2
47

Solution:
Therefore, APR = 15%
Interest rate/month = 15%/12months = 1.25%
Effective interest rate per quarter = (1+0.0125)3
1 = 0.038 or, 3.8%
Therefore, P = $1,000 (P/A, 3.8%, 8) =
$6,788.70
Qrtr = $1,000

End of year 1

By: Dr. Magdy Akladios

End of year 2

48

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Ch4: Understanding Money & It's

Management

Discrete Case: Quarterly deposits with Monthly

compounding

Year 1
0

Year 2
4

F=?

Year 3
8

9 10 11

12

Quarters

A = $1,000
Step 1: M = 12 compounding periods/year
K = 4 payment periods/year
C = 3 interest periods per quarter
Step 2: i [1 0 .12 /( 3)( 4 )] 3 1

3 .030 %
Step 3:
Step 4:

N = 4(3) = 12
F = $1,000 (F/A, 3.030%, 12)
= $14,216.24
49

Continuous Case: Quarterly deposits with Continuous

compounding

Year 1
0

Year 2
4

F=?

Year 3
8

9 10 11

12

Quarters

A = $1,000

Step 1: K = 4 payment periods/year

C = interest periods per quarter
Step 2:
0.12/ 4

ie

3.045% per quarter

Step 3:
Step 4:

N = 4(3) = 12
F = $1,000 (F/A, 3.045%, 12)
= $14,228.37
50

Example
A series of equal quarterly payments of
$5,000 for 10 years is equivalent to what
present amount at an interest rate of 9%
compounded
(a) quarterly
(b) monthly
(c) continuously
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By: Dr. Magdy Akladios

17

Ch4: Understanding Money & It's

Management

Solution
A = $5,000

0
1

40 Quarters

52

(a) Quarterly
Payment period :
Quarterly
Interest Period:
Quarterly

A = $5,000

0
1

40 Quarters

9%
2.25% per quarter
4
N 40 quarters
P $5,000( P / A, 2.25%, 40)
$130,968
i

53

(b) Monthly

A = $5,000

0
1

40 Quarters

Payment period :
Quarterly
Interest Period: Monthly

9%
0.75% per month
12
i p (1 0.0075)3 2.267% per quarter
i

N 40 quarters
P $5, 000( P / A, 2.267%, 40)
$130,586
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By: Dr. Magdy Akladios

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Ch4: Understanding Money & It's

Management

(c) Continuously

A = $5,000

0
1

Payment period :
Quarterly
Interest Period:
Continuously

40 Quarters

i e0.09/ 4 1 2.276% per quarter

N 40 quarters
P $5, 000( P / A, 2.276%, 40)
$130,384
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A Decision Flow Chart on How to Compute the

Effective Interest Rate per Payment Period

56

Compounding LESS often than

Payment period

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By: Dr. Magdy Akladios

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Ch4: Understanding Money & It's

Management

Example
Interest accrues quarterly
Payment is monthly
APR = 12%
ieff (for the month) = [1+ 0.12/4]4/12 -1 = 0.0099
or 0.99%
Where:
m is the number of times during the period that
interest is compounded
n is the number of payments to be made during that
period.
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By: Dr. Magdy Akladios

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