Nominal and Effective

Interest Rates

By: Eng’r. Danielle D. Cabaña


Learning Outcomes:
Purpose: Make economic
calculations for interest rates and
cash flows that occur on a time
basis other than 1 year.
1. Understand nominal and effective
interest rate statements.
2. Determine the effective interest
rate for any time period.
3. Determine the correct i and n
values for different payment and
compounding periods.
4. Make equivalence equations for
various payment periods and
compounding periods when only
single amounts occur
Interest rates that vary with time

Ashea Smith is a 22-year-old senior who used the Stafford loan program
to borrow $4,000 four years ago when the interest rate was 4.06% per
year. $5,000 was borrowed three years ago at 3.42%. Two years ago she
borrowed $6,000 at 5.23%, and last year $7,000 was borrowed at
6.03% per year. Now she would like to consolidate her debt into a single
20-year loan with a 5% fixed annual interest rate. If Ashea makes annual
payments (starting in one year) to repay her total debt, construct the
cash flow diagram that clarifies the timing of Ashea’s loans and applicable
interest rates.
Interest rates that vary with time
Nominal and Effective Interest Rates

Very often the interest period, or time between successive compounding,

is less than one year (e.g., daily, weekly, monthly, or quarterly). It has
become customary to quote interest rates on an annual basis, followed by
the compounding period if different from one year in length.
Nominal and Effective Interest Rates

For example, if the interest rate is 6% per interest period and the interest
period is six months, it is customary to speak of this rate as “12%
compounded semiannually.”

A nominal interest rate is represented by r. But the actual (or effective)

annual rate on the principal is not 12%, but something greater, because
compounding occurs twice during the year.
TERMINOLOGIES

APR (Annual Percentage Rate) – often stated as the annual interest rate
for credit cards, loans, and house mortgages”. This is the same as the
nominal interest rate. An APR of 15% is the same as a nominal 1.25%
per month.
APY (Annual Percentage Yield) – commonly stated annual rate of return
for investments, certificates of deposit, and savings accounts. This is the
same as effective rate.

As we will discover , the nominal rate NEVER exceeds the effective rate,
similarly APR<APY.
Nominal and Effective Interest rate

We could calculate the total annual interest payment for a credit card debt of
Php1,000 with an APR of 15%, or nominal 1.25% per month using:
𝐹 =𝑃 1+𝑖 𝑁
Where, i = 1.25% per month; N = 12
𝐹 = 𝑃ℎ𝑝1000 1 + 0.0125 12 = 𝑃ℎ𝑝 1,160.75

Clearly, that value is greater than an interest rate of 15% per year. Therefore the bank is
basically earning from your loan. To compute the EFFECTIVE INTEREST:

𝑃ℎ𝑝160.75
𝑖𝑒 = = 0.1608 = 𝟏𝟔. 𝟎𝟖%
𝑃ℎ𝑝1,000.00
Specific Examples

Interest Rate Statement Nominal or Effective Compounding

Interest Period
15% per year compounded monthly Nominal Monthly
15% per year Effective Yearly
Effective 15% per year compounded monthly Effectively Monthly
20% per year compounded quarterly Nominal Quarterly
Nominal 2% per month compounded weekly Nominal Weekly
2% per month Effectively Monthly
2% per month compounded monthly Effectively Monthly
Effectively 6% per quarter Effective Quarterly
Effectively 2% per month compounded daily Effective Daily
FORMULAS

Every nominal interest rate must be converted into an effective rate before it can be used in
formulas, factor tables, calculator, or spreadsheet functions because they are all derived
using effective rates.

We let r – the nominal interest rate for that period, i – the effective interest rate for a
certain period, m – number of times interest is compounded in that same period, often
called the compounding frequency.

𝑟 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 × 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

𝒓 𝒎
𝒊 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝟏 + −𝟏
𝒎
EXAMPLE

a. A Visa credit card issued through Frost Bank carries an interest

rate of 1% per month on the unpaid balance. Calculate the
effective rate per semiannual and annual periods.
b. If the card’s interest rate is stated as 3.5% per quarter, find the
effective semiannual and annual rates.
Equivalence calculations involving only
single-amount factors

Sherry expects to deposit $1000 now, $3000 four years from now,
and $1500 six years from now and earn at a rate of 12% per year
compounded semiannually through a company-sponsored savings
plan. What amount can she withdraw 10 years from now?
ANSWER THE FOLLOWING:

1. Fill in the table of Annual Effective Yields at Various Compounding Intervals:

Nominal Annually Semiannually Quarterly Monthly Daily

Rate
4% 4.00% 4.04% 4.06% 4.07% 4.08%
7% 7.00% 7.12% 7.19%
10% 10.00% 10.25%
15% 15.00%
Assignment: Write your answer and solution
on a long bond paper.

1.Suppose that you make quarterly deposits into a savings account

that earns 8% interest compounded monthly. Compute the
effective interest rate per quarter. Ans. 2.013%
2.Find the effective interest rate per quarter at a nominal rate of
8% compounded (a) weekly. (b) daily. Ans. a.) 2.0186%, b.)
2.0199%