Nominal & Effective Rates

Three Kinds of Rates in Compound Interest

Periodic Rate (i)rate used to compute compound interest and it is equal to interest rate (r) divided by the conversion period (m) Nominal Rate (J) rate quoted when interest is compounded more than once a year Effective Rate (e) - rate quoted when interest is compounded annually

Nominal Rate

J = m[(1 + e)
where: year

1/ m

1]

J = nominal rate m = conversion period per e = effective rate

Examples:

1. What nominal rate compounded monthly, will yield an effective rate of 5 1/2%?

2. What nominal rate compounded semi-annually, will yield an effective rate of 4 1/2%? 3. What rate converted quarterly yields the effective rate 7%? 4. If interest is compounded quarterly, find the nominal rate which yield an effective rate of 6 1/2%. 5. If interest is compounded quarterly, find the nominal rate which will yield an effective rate of 4 1/4%.

Effective Rate

e = [(1 + J / m) 1]
m
where: year e = effective rate m = conversion period per J = nominal rate

Examples:

1. When interest is compounded monthly, find the effective rate corresponding to the nominal rate 3%.

2. Find the effective rate corresponding to the rate 13% compounded: a. Semi-annually. b. Quarterly. c. Monthly. 3. Should I invest in a savings and loan association paying 7% converted quarterly or in bonds yielding 7 1/2% effective? 4. If you have P150000 to invest, what would be the difference in interest rate in one year, if you invest at 10% compounded quarterly and 10% compounded monthly?