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Nominal vs Effective Interest Rates

1) Nominal interest rates refer to the quoted annual rate, while effective rates refer to the actual rate earned over various compounding periods, such as monthly, quarterly, etc. 2) Calculating effective rates allows accurate comparisons of investments with different compounding schedules. For example, 18% compounded monthly equals an effective annual rate of 19.56%. 3) Practice problems demonstrated calculating balances, interest earned, and rates for various savings and credit scenarios involving nominal rates, compounding periods, and time horizons.

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121 views18 pages

Nominal vs Effective Interest Rates

1) Nominal interest rates refer to the quoted annual rate, while effective rates refer to the actual rate earned over various compounding periods, such as monthly, quarterly, etc. 2) Calculating effective rates allows accurate comparisons of investments with different compounding schedules. For example, 18% compounded monthly equals an effective annual rate of 19.56%. 3) Practice problems demonstrated calculating balances, interest earned, and rates for various savings and credit scenarios involving nominal rates, compounding periods, and time horizons.

Uploaded by

MUHAMMAD QASIM
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd

(HM-231) Engineering Economics

Nominal & Effective


Interest Rate
Lecture #7

1 12/5/2019
Flash Back from before break
The Five Types of Cash Flows

(a) Single cash flow


(b) Equal (uniform)
payment series
(c) Linear gradient
series
(d) Geometric
gradient series
(e) Irregular
payment series
Nominal and Effective Interest
Rates

 Nominal and Effective


Interest Rates
 Equivalence Calculations
using Effective Interest
Rates

 Debt Management
Focus
1. If payments occur more frequently than
annual, how do you calculate economic
equivalence?
2. If interest period is other than annual,
how do you calculate economic
equivalence?
3. How are commercial loans structured?
4. How should you manage your debt?
Nominal Versus Effective Interest Rates

Nominal Interest Rate: Effective Interest Rate:


Interest rate quoted Actual interest earned
based on an annual or paid in a year or
period some other time period
18% Compounded Monthly

Nominal Interest
interest rate period

Annual
percentage
rate (APR)
18% Compounded Monthly
 What It Really Means?
 Interest rate per month (i) = 18%/12 = 1.5%
 Number of interest periods per year (N) = 12
 In words,
 Bank will charge 1.5% interest each month on your
unpaid balance, if you borrowed money
 You will earn 1.5% interest each month on your
remaining balance, if you deposited money
18% compounded monthly

 Question: Suppose that you invest $1 for 1 year at


18% compounded monthly. How much interest
would you earn?
 Solution:
F  $1(1  i )12  $1(1  0.015)12
= $1.1956
ia  0.1956 or 19.56%
18%

= 1.5%
Effective Annual Interest Rate (Yield)

ia  (1  r / M )  1 M

r = nominal interest rate per year


ia = effective annual interest rate
M = number of interest periods per
year
18%

: 1.5%
18% compounded monthly
or
1.5% per month for 12 months
=

19.56 % compounded annually


Practice Problem
 If your credit card calculates the interest based on
12.5% APR, what is your monthly interest rate
and annual effective interest rate, respectively?
 Your current outstanding balance is $2,000 and
skips payments for 2 months. What would be the
total balance 2 months from now?
Solution
Monthly Interest Rate:
12.5%
i  1.0417%
12
Annual Effective Interest Rate:
ia  (1  0.010417)12  13.24%
Total Outstanding Balance:
F  B2  $2, 000( F / P,1.0417%, 2)
 $2, 041.88
Practice Problem
 Suppose your savings account pays 9% interest
compounded quarterly. If you deposit $10,000
for one year, how much would you have?
Solution
(a) Interest rate per quarter:
9%
i  2.25%
4
(b) Annual effective interest rate:
ia  (1  0.0225) 4  1  9.31%
(c) Balance at the end of one year (after 4 quarters)
F  $10, 000( F / P, 2.25%, 4)
 $10, 000( F / P, 9.31%,1)
 $10, 931
Nominal and Effective Interest Rates
with Different Compounding Periods
Effective Rates
Nominal Compounding Compounding Compounding Compounding Compounding
Rate Annually Semi-annually Quarterly Monthly Daily

4 4.00% 4.04% 4.06% 4.07% 4.08%

5 5.00 5.06 5.09 5.12 5.13

6 6.00 6.09 6.14 6.17 6.18

7 7.00 7.12 7.19 7.23 7.25

8 8.00 8.16 8.24 8.30 8.33

9 9.00 9.20 9.31 9.38 9.42

10 10.00 10.25 10.38 10.47 10.52

11 11.00 11.30 11.46 11.57 11.62

12 12.00 12.36 12.55 12.68 12.74


Effective Annual Interest Rates
(9% compounded quarterly)
Base amount $10,000
First quarter
+ Interest (2.25%) + $225

= New base amount = $10,225


Second quarter
+ Interest (2.25%) +$230.06

= New base amount = $10,455.06


Third quarter
+ Interest (2.25%) +$235.24

= New base amount = $10,690.30


Fourth quarter
+ Interest (2.25 %) + $240.53
= Value after one year = $10,930.83
Effective Interest Rate per Payment Period
(i)

i  [1  r / CK ]  1C

C = number of interest periods per


payment period
K = number of payment periods per year
CK = total number of interest periods per
year, or M
r/K = nominal interest rate per
payment period
12% compounded monthly
Payment Period = Quarter
Compounding Period = Month

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

1% 1% 1%
3.030 %
One-year
• Effective interest rate per quarter
i  (1  0.01)3  1  3.030%
• Effective annual interest rate
ia  (1  0.01)12  1  12.68%
ia  (1  0.03030)4  1  12.68%

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