NOMINAL RATE AND EFFECTIVE RATES OF INTEREST
Rate of Interest
is the cost of borrowing money.
It also refers to the amount earned by a unit principal per unit time.
Two Types of Rates of Interest
NOMINAL RATE OF EFFECTIVE ANNUAL CONTINUOUS
INTEREST RATE OF INTEREST COMPOUNDING
Basic annual rate of interest or
The exact rate of interest
annual interest rate without
earned on the principal
taking compounding into
during a one year period
account. Interest is compounded an
infinite number of times
The actual interest earned or
The stated interest rate on a per year
paid in one year, accounting
financial product, not
for the effect of
accounting for the effect of
compounding.
compounding within the year.
NR = m x i ER = [1 + ] – 1 ER = 𝑒 − 1
where: where:
m = number of where:
r = nominal annual rate r = nominal rate
compounding periods per
year m = number of
i = periodic interest rate compounding periods
per year
Use Case Use Case
Appears in Used to compare
advertisements for financial products on
loans and credit cards. an apples-to-apples
Easy to calculate and basis.
communicate. Preferred for
Doesn’t reflect the real investment
cost or return due to evaluation and loan
ignoring compounding analysis.
effects. Often required by
law for disclosure
(e.g., APY in U.S.
savings products).
Formula (Nominal and Effective Rates)
𝟏
𝑵𝑹 𝒎
ER = [𝟏 + 𝒊 ]𝒎 – 1 or ER = [𝟏 + 𝒎
] – 1 or NR = 𝐦[(𝟏 + 𝐄𝐑 )𝐦 – 1]
m Number of compounding period per year
i= Interest per period
NR Nominal rate of interest
Note: i = NR The mode of compounding is annually
Note: The more frequently interest is compounded, the higher the effective rate becomes — even if
the nominal rate is fixed.
Sample Problems:
1. A principal is invested at 5% compounded quarterly.
In this statement, the nominal rate is 5% while the effective is greater than 5% because of the
compounding which occurs four times a year. The following formula is used to determine the
effective rate of interest:
Solution:
NR = 5%, m = 4
ER = [1 + ] –1
Substituting the values of m and i:
.
ER = [1 + ] –1
ER = 0.0509
ER = 5.09%
So, the actual interest rate is not just 5% but 5.09%. However, the effective rate and nominal rate
are equal if the mode of compounding is per annum or annually.
2. What is the effective rate corresponding to 18% compounded daily? Take 1 year is equal to 360
days.
Solution:
ER = [1 + 𝑖] − 1
.
ER = [1 + ] −1
ER = 19.72%
3. Mandarin Bank advertises 9.5% account that yields 9.84% annually. Find how often the interest is
compounded.
ER = [1 + 𝑖] − 1
.
0.0984 = [1 + ] −1
.
1.0984 = [1 + ]
By trial and error, m = 4.
There are 4 interest periods per year, thus the interest is compounded quarterly.
4. A loan has a nominal annual interest rate of 12%, compounded monthly. What is the effective
annual rate?
.
ER = [1 + ] −1
ER = 0.1268 or 12.68%
5. An investment offers a nominal interest rate of 8% compounded quarterly. What is the effective
annual rate?
.
ER = [1 + ] −1
ER = 0.0824 or 8.24%
6. You are offered an investment with an effective annual rate of 10.25%. Interest is compounded
monthly. What is the nominal annual rate?
NR = 12[(1 + 0.1025) − 1]
NR = 0.098 or 9.8%
Activity: Copy and answer. Write your solution in a newsprint and box your final answer. Avoid
erasures.
1. What nominal rate compounded semi-annually, yields the same amount as 16% compounded
quarterly?
2. Which option offers a better return?
Option A: 10% annual rate compounded monthly
Option B: 10.2% annual rate compounded quarterly
3. Which of these gives the lowest effective rate of interest?
4. You invest $1,000 at a nominal rate of 7% compounded continuously. What is the effective
annual rate?
5. An investment offers a nominal interest rate of 8% compounded quarterly. What is the
effective annual rate?
6. You are offered two credit cards: Which card has the lower effective interest rate?
Card A: 18% APR, compounded monthly
Card B: 17.75% APR, compounded daily
7. Compute the equivalent rate of 6% compounded semi-annually to a rate compounded
quarterly.