Nominal and Effective

Interest Rates
The term “nominal”
Nominal means, “in name only”,
not the real rate in this case.
 Over View
 The difference between nominal and
effective interest rates is that nominal
means once per year and effective
means compounding more than once
per year .
 Nominal interest rate, r, is an interest
rate that does not include any
consideration of compounding.
A given principal set deposited at
the same nominal rate of interest
will earn different effective rates of
interest depending on the type of
compounding.
Nominal
 r = interest rate per period x number of
periods
Examples – Nominal Interest
Rates
 1.5% per month for 24 months
 Same as: (1.5%)(24) = 36% per 24 months
 1.5% per month for 12 months
 Same as (1.5%)(12 months) = 18%/year
 1.5% per 6 months
 Same as: (1.5%)(6 months) = 9%/6
 months or semiannual period
 1% per week for 1 year
 Same as: (1%)(52 weeks) = 52% per year
 A nominal rate may be stated for any period: 1 year,
6 months, weekly, daily.
 r = 1.5% per month x 12 months = 18%
 Considering 2% per month, all the following are
same:
 2% per month x 12 months = 24% per year
 2% per month x 24 months = 48% per 2 years
 2% per month x 6 months = 12% seminanually
 2% per month x 3 months = 6% quarterly
 2% per month x .231 months = .462 weekly
 2% per month x 1/365 months = .005479 daily
 Note that the nominal rates do NOT make
mention of the compounding period, there
is no compounding period by definition.
 Given: 18% per year, compounded monthly
 Find: Nominal interest rate per
 2 month
 6 months
 2 years
 month
 i/month = 18/12 = 1.5
 r/2months = 1.5 x 2
 r/2months = 3%
 6 months
 r/6months = 1.5 x 6
 r/6months = 9%
 2 years
 r/2years = 1.5 x 24
 r/years = 36%
Normal Format
Focus on the Differences
 Nominal Rates:
 Format: “r% per time period, t”
 Ex: 5% per 6-months”
 Effective Interest Rates:
 Format: “r% per time period, compounded ‘m’
 times a year.
 ‘m’ denotes or infers the number of times per year
 that interest is compounded.
 Ex: 18% per year, compounded monthly
 An effective rate has the compounding
frequency attached to the nominal rate
statement. If the compounding frequency
is NOT stated, it assumed to be the same
time period as r meaning that the nominal
and effective rates are the same.
Effective Interest Rate

 Effective interest rate is the actual rate

that applies for a stated period of time.
The compounding of interest during the
time period of the corresponding nominal
rate is accounted for by the effective
interest rate. It is commonly expressed on
an annual basis as the effective annual
rate ia, but any time basis can be used.
Example

 Given, “9% per year, compounded

 quarterly”
 Qtr. 1 Qtr. 2 Qtr. 3 Qtr. 4
 One Year: Equals 4 Quarters
 CP equals a quarter (3 months)
 Given, “9% per year, compounded
 quarterly”
 Qtr. 1 Qtr. 2 Qtr. 3 Qtr. 4
 What is the Effective Rate per Quarter?
 iQtr. = 0.09/4 = 0.0225 = 2.25%/quarter
 9% rate is a nominal rate;
 The 2.25% rate is a true effective
 monthly rate
Statement: 9% compounded monthly
 r = 9% (the nominal rate).
 “compounded monthly means “m” =12.
 The true (effective) monthly rate is:
 0.09/12 = 0.0075 = 0.75% per month
Statement: 4.5% per 6 months –
compounded weekly
 Nominal Rate: 4.5%.
 Time Period: 6 months.
 Compounded weekly:
 Assume 52 weeks per year
 6-months then equal 52/2 = 26 weeks per 6
 months
 The true, effective weekly rate is:
 (0.045/26) = 0.00173 = 0.173% per week
 The following do NOT have the same
effective rate over all time periods due to
different compounding frequencies.
 12% per year, compounded monthly
 12% per year, compounded quarterly
 3% per quarter, compounded quarterly
Units associated with an interest
rate statement
• Time period – the basic time unit of the interest rate.
This is the t in the statement of r % per time period t.
The time unit of 1 year is by far the most common
and 1 year is assumed unless otherwise stated.
• Compounding period (CP) – the time unit used to
determine the effect of interest. It is defined by the
compounding term in the interest rate statement. If
not stated, it is assumed to be a year.
 The compounding frequency is the
number m, which is the number of times
that compounding occurs within t, the time
period. 8% per year compounded monthly
has m=12. If 8% is compounded daily,
m=365.
 In the previous chapters t = m = 1 year
meaning that the effective and nominal
rates were equal.
Time Periods Associated with
Interest
 Payment Period, Tp - Length of time during
 which cash flows are not recognized except
 as end of period cash flows.
 Compounding Period, Tc - Length of time
 between compounding operations.
 Interest Rate Period, T - Interest rates are
 stated as % per time period.
 It is common to express the effective rate on the
same time basis as the compounding period.
 Effective rate per CP (Compounding Period) = =
 Given: r = 6% per year, compounded monthly
 Find: CP
 CP =r/m = 6/12
 CP = .50% per month
3 ways to express interest rates
 8% per year compounded quarterly, 8% is
nominal and the effective must be calculated
 Effective 8.243% per year compounded quarterly,
8.243% is the effective rate and may be used
directly.
 8% per year, ambiguous because no
compounding period is stated. The rate is
effective only over the time period of one year;
the effective rate for any other time period must
be calculated.
 It can be unclear as to whether a stated
 rate is a nominal rate or an effective
 rate.
 Three different statements of interest
 follow………
8% per year, compounded
quarterly”
 Nominal rate is stated: 8%
 Compounding Frequency is given
 Compounded quarterly
 True quarterly rate is 0.8/4 = 0.02
 = 2% per quarter
 Here, one must calculate the effective
 quarterly rate!
Effective Rate Stated

 “Effective rate = 8.243% per year,

 compounded quarterly:
 No nominal rate given (must be calculated)
 Compounding periods – m = 4
 No need to calculated the true effective
 rate!
 It is already given: 8.243% per year!
Only the interest rate is stated
“8% per year”.
 Note:
 No information on the frequency of compounding.
 Must assume it is for one year!
 “m” is assumed to equal “1”.
 Assume that “8% per year” is a true,
 effective annual rate!
 No other choice!
Effective Annual Interest Rates
 The most common period is a year by far which
is considered in this section.
 r = nominal interest rate per year
 m = number of compounding periods per year
 i = effective interest rate per compounding
period CP = r/m
 ia = effective interest rate per year
 F = P + Pia = P(1+ia)
 CP must be compounded through all m
periods to obtain the total.
 F = P(1+i)m
 Consider of the F value for a present worth
P of $1 and equating the two expressions for
F and substituting $1 for P:
 1+ia = (1+i)m
 ia = (1+i)m –1
 Solving for the effective interest rate:
 i = (1+ia)1/m –1
Effective Interest Rates for Any
Time Period
 The payment period, PP, is the frequency
of payment or receipts. To evaluate cash
flows that occur more frequently than
annually, PP<1 year, the effective interest
rate over the PP must be used in the
engineering economy relations.
Substituting r/m for the period interest rate
in eq. 4.5 yields
 Given:
 interest is 8% per year compounded
 quarterly”.
 What is the true annual interest rate?
 Calculate:
 EAIR = (1 + 0.08/4)4 – 1
 EAIR = (1.02)4 – 1 = 0.0824 = 8.24%/year
 Example: “18%/year, comp. monthly”
 What is the true, effective annual
 interest rate?
 r = 0.18/12 = 0.015 = 1.5% per month.
 1.5% per month is an effective monthly
 rate.
 The effective annual rate is:
 (1 + 0.18/12)12 – 1 = 0.1956 = 19.56%/year
 Example: EAIR given a nominal rate.
 Given:
 interest is 8% per year compounded
 quarterly”.
 What is the true annual interest rate?
 Calculate:
 EAIR = (1 + 0.08/4)4 – 1
 EAIR = (1.02)4 – 1 = 0.0824 = 8.24%/year
 Example: “18%/year, comp. monthly”
 What is the true, effective annual
 interest rate?
 r = 0.18/12 = 0.015 = 1.5% per month.
 1.5% per month is an effective monthly
 rate.
 The effective annual rate is:
 (1 + 0.18/12)12 – 1 = 0.1956 = 19.56%/year
 APY & APR
 The Annual Percentage Rate, APR, is the
same as the nominal interest rate, and the
Annual Percentage Yield, APY, is used in
lieu of effective interest rate.
Examples
 An interest rate of effective 12% per year
compounded monthly is = ?
 If you deposit $1000 per month into an
account which pays interest at a rate of
12% per year compounded monthly, the
amount of money you would have at the
end of five years is =?
 The owner of a small business borrowed
$70,000 with an agreement to repay the
loan with quarterly payments over a five
year time period. If the interest rate is 12%
per year compounded quarterly, his loan
payment each quarter is=?
 A metal plating company wants to set
aside money now to prepare for a lawsuit
it expects to face in four years. If the
company wants to have $1,000,000
available at that time, how much must it
set aside now in one lump sum if the
account will earn 1% per month?
 For an interest rate of 2% per month, the
effective semiannual rate is=?