PRACTICE

CATHOLIC UNIVERSITY OF SAINT

MARÍA
Engineering Practice Guide
Economic
4
Interest Rates
Nominal and Effective
OBJECTIVES

Define capitalization period, payment period, nominal interest rate, and rate of
effective interest.
Calculate the effective interest rate.
Calculate the present and future value of a specific cash flow when the period of
capitalization is shorter or longer than the payment period.

RESOURCES

Paper
Calculator
Blackboard
Computer.
Practice Guide.

DURATIONOFTHEPRACTICE

One session (1 hour).

THEORETICAL FRAMEWORK
1. NOMINAL INTEREST AND EFFECTIVE INTEREST

The nominal interest is a simple reference interest rate from which and
depending on the capitalization condition, the effective rate is obtained. The period of
capitalization (which is also known as interest period) determines the timing of
settlement or accusation of interests, regardless of whether they are paid or not. The
effective interest is the true interest rate obtained from an investment or that is

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incurs for a loan. The effective annual interest will be the interest that we would obtain after
if we reinvested the interest returned by the investment during that period
same year, at the same interest rate originally agreed upon.
The effective interest can be calculated for any period other than a year.
To know the effective rate, it is generally required to know the nominal rate and the
capitalization condition. There are cases in which such information is not required. The
It is a commercial custom to express interest rates annually.

It is very important to distinguish between the capitalization period and the payment period. For example,
if a company deposits money every month in an account that pays a nominal interest
annual of 30% capitalized biannually, the payment period will be one month, while
that the capitalization period will be six months. Likewise, if a person
deposit money every year in a savings account that compounds interest quarterly,
The payment period is one year, while the capitalization period is three months.

When talking about compound interest, the monthly interest rate is not equivalent to the
which results from dividing the annual amount by 12. Thus, an annual compound return of 30% is not
equivalent to a monthly rate of 2.5% (30/12). This is where the difference lies.
the nominal and effective interest.

The effective annual yield of an investment that pays interest in arrears increases by
the shorter the agreed period for payments is. To develop the formula
For the effective interest, we will use the following symbolism:

r Nominal interest rate

i Effective annual interest rate
r/t Effective rate of the capitalization period.
t Number of compounding periods.

i = [ (1 + r )t] - 1
t

r/t = [ ( 1 + (1i/ t) )1

r/t = nominal interest / compounding periods

By dividing the nominal rate by the number of compounding periods, we obtain the rate.
effective for that period.

To illustrate the difference between the nominal interest rate and the effective interest rate, the
The future value of $100.00 after one year is determined by both rates. If a
The bank pays 8% interest compounded semiannually, the future value of $100.00
using a nominal interest rate of 8% per year is:

F = P (1+i)n= 100 (1.08)1$108.00

On the other hand, if it is capitalized semiannually, the future value must include interest on the
interest earned in the first period. An annual interest rate of 8% compounded
Semiannually means that the bank will pay 4% interest twice a year. So:

F = P (1+i)n = 100 (1+0.04)2$108.16

Nominal = 8% per year

Cash = 4% per period

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2. ANNUAL EFFECTIVE INTEREST RATES

Example:

A credit company announces that its interest rate for loans is 1%

monthly. Calculate the annual effective interest rate and find the corresponding P/F factor
for n = 8

Replacing in the equation:

i = [ (1 + r )t] - 1
t

i = [ (1 + 0.01 )12– 1 = 0.1268 = 12.68%

3. EQUIVALENCE RELATIONS: COMPARISON BETWEEN DURATION OF

PAYMENT PERIOD AND CAPITALIZATION PERIOD (PP VERSUS PC)

In the calculations of equivalence with high percentages, the frequency of cash flows
is not equal to the frequency of interest capitalization. For example, the flows of
cash can be annual, quarterly, or more frequent. Consider the deposits
made in a savings account every month, whose yields have a period of
quarterly capitalization. The duration of the PC is one quarter, while the duration of
PP is one month. To properly carry out the equivalence calculations, it turns out
essential that the same period is used for the capitalization period and the period of
payment, and consequently the interest rate is adjusted.

3.1 EQUIVALENCE RELATIONS: ONE-TIME PAYMENTS WITH PP >= PC

There are two ways to determine the P/F and F/P factors:

Method 1: The effective interest rate during the compounding period PC is determined, and
N is equal to the number of compounding periods between P and F. Then:
P = F ( P/F, effective interest rate i%, total number of periods n )
F = P ( F/P, effective interest rate i%, total number of periods n)
If a credit card has an established interest rate of 15% compounded monthly
for two years, then the PC = 15% / 12 = 1.25%, and n = 2 * 12 = 24
Then: (P/F, 1.25%, 24) = 0.7422

Method 2: The effective interest rate for period t is determined from the nominal rate, yn
equal to the total number of periods using the same period.
i = [ (1 + 0.15 )12] - 1 = 16.076 %, n = 2
12
Then: (P/F, 16.076%, 2) = 0.7422

3.2 EQUIVALENCE RELATIONS: SERIES WITH PP >= PC

When the cash flows involve a series (for example A, G) and the payment period is
equal to or greater than the capitalization period:

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The effective interest rate is calculated per payment periods.

They are determined as the total number of payment periods.

For example:

Flow series of
Interest rate What to find Standard notation
cash
$ 800 20% per year,
semiannually composed Find P given A P = 800 (P/A, 10%, 14)
for 7 years monthly
$ 150 36% annual
monthly composed Find F given A F = 150 (P/A, 3%, 36)
for 3 years semiannually
$ 420
quarterly 7% quarterly Find F given A F = 420 (P/A, 7%, 40)
for 10 years
Increase of $
20 monthly 1.5% monthly Find P given G P = 20 (P/G, 1.5%, 72)
for 6 years
$ 163
quarterly 1% monthly Find A given P A = 163 (A/P, 3.03%, 24)
for 6 years

3.3 RELACIONES DE EQUIVALENCIA: PAGOS ÚNICOS Y SERIES CON PP < PC

When cash flows involve single payments or a series, and the payment period is
less than the capitalization period, interperiodic capitalization does not occur, since the
cash flows between periods do not earn interest or earn compound interest.

Deposits (negative cash flows) are considered to be made at the end of the period.
of capitalization; likewise, it is considered that withdrawals are made at the beginning. For example,
if there is a quarterly compound interest, the monthly deposits are transferred to the end of the
quarter (no interperiodic interest is obtained) and all withdrawals are transferred to
principal (no interest is paid throughout the quarter).

PRACTICE ACTIVITIES

1. Calculate the future value of a series of equal monthly payments of $1000 that are
extended for a period of five years at a compounded interest of 12%: a)
["quarterly","monthly"]
2. ¿Cuál es el valor futuro total de las siguientes series de pagos? $ 1,000 al final de cada
semestre durante 10 años al 8% compuesto semestralmente. $ 1,000 al final de cada
quarterly for 10 years at 10% compounded quarterly.

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3. What is the amount of the quarterly deposits for you to be able to withdraw the
amounts indicated in the figure if the interest rate is 8% compound
quarterly?

$ 2500
$ 2000
$ 1500
$ 1000

0 1 2 3 4 5 6 7 8

Georgi Rostov deposits $4,000 today in a savings account that pays 6% interest.
quarterly compounded. Three years later, he deposits $4,500; two years
After this deposit, make another for $2,500; four years after the deposit.
From $2,500, transfer half of the accumulated funds to a fund that pays 7%.
monthly compound interest. How much money will there be in each of the accounts?
six years after the transfer?
5. The price of a building is $75,000. If an initial payment of $25,000 is made and a
Monthly payment of $500 while required. How many years will be needed to pay off the
building?. Is the interest charged at a rate of 9% compounded monthly?
6. A couple is thinking about financing their three-year-old son's college education. The money
It can be deposited at 8% compounded quarterly. What quarterly deposit should be made?
to take place from the child's third birthday until they turn 18 years old for
provide $20,000 on each birthday from the 18th to the 21st? (Note
that the last deposit is made on the day of the first withdrawal.
Elimy Lazi received $20,000 from an insurance company after the death of her
husband. Emily wants to deposit this amount into a savings account that produces a
8% interest compounded monthly. After that, he would like to make 60 withdrawals.
equal monthly payments over the five-year deposit period, so that at
to make the last withdrawal, the savings account must have a zero balance. How much can be withdrawn?
every month?

QUESTIONNAIRE

1) What is the difference between nominal interest rate and effective interest rate?
2) What is the difference in equivalence relationships in lump-sum payments, series
regarding PP >= PC?
3) What calculations should be performed in the equivalence relationships in single payments?
series regarding PP >= PC?
4) What calculations must be performed in equivalence relationships in single payments?
series regarding PP < PC?

BIBLIOGRAPHIC REFERENCES

[ 1 ] Chan S. Park, “Ingeniería Económica Contemporánea”, Ed. Addison Wesley, 1997.

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Tarkin "Economic Engineering", Ed. McGraw Hill, 2003.

AT TA C H E D D O C U M E N T S

None

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