Nominal interest rate

In nance and economics, nominal interest rate or

nominal rate of interest refers to two distinct things: the
rate of interest before adjustment for ination (in contrast
with the real interest rate); or, for interest rates as stated
without adjustment for the full eect of compounding
(also referred to as the nominal annual rate). An in-
terest rate is called nominal if the frequency of com-
pounding (e.g. a month) is not identical to the basic
time unit (normally a year).
1 Nominal versus real interest rate
The real interest rate is the nominal rate of interest minus
ination. In the case of a loan, it is this real interest that
the lender receives as income. If the lender is receiving
8 percent from a loan and ination is 8 percent, then the
real rate of interest is zero because nominal interest and
ination are equal. A lender would have no net benet
from such a loan because ination fully diminishes the
value of the loans prot.
The relationship between real and nominal interest rates
can be described in the equation:
(1 + r)(1 + i) = (1 + R)
where r is the real interest rate, i is the ination rate, and
R is the nominal interest rate.
[1]
A common approximation for the real interest rate
is:
real interest rate = nominal interest rate - ex-
pected ination
In this analysis, the nominal rate is the stated rate, and the
real interest rate is the interest after the expected losses
due to ination. Since the future ination rate can only
be estimated, the ex ante and ex post (before and after the
fact) real interest rates may be dierent; the premiumpaid
to actual ination may be higher or lower. In contrast, the
nominal interest rate is known in advance.
2 Nominal versus eective interest
rate
The nominal interest rate (also known as an Annualised
Percentage Rate or APR) is the periodic interest rate
multiplied by the number of periods per year. For ex-
ample, a nominal annual interest rate of 12% based
on monthly compounding means a 1% interest rate per
month (compounded).
[2]
Anominal interest rate for com-
pounding periods less than a year is always lower than the
equivalent rate with annual compounding (this immedi-
ately follows from elementary algebraic manipulations of
the formula for compound interest). Note that a nomi-
nal rate without the compounding frequency is not fully
dened: for any interest rate, the eective interest rate
cannot be specied without knowing the compounding
frequency and the rate. Although some conventions are
used where the compounding frequency is understood,
consumers in particular may fail to understand the im-
portance of knowing the eective rate.
Nominal interest rates are not comparable unless their
compounding periods are the same; eective interest
rates correct for this by converting nominal rates into
annual compound interest. In many cases, depending on
local regulations, interest rates as quoted by lenders and
in advertisements are based on nominal, not eective in-
terest rates, and hence may understate the interest rate
compared to the equivalent eective annual rate.
Confusingly, in the context of ination, 'nominal' has a
dierent meaning. A nominal rate can mean a rate be-
fore adjusting for ination, and a real rate is a constant-
prices rate. The FIsher equation is used to convert be-
tween real and nominal rates. To avoid confusion about
the term nominal which has these dierent meanings,
some nance textbooks use the term'Annualised Percent-
age Rate' or APR rather than 'nominal rate' when they
are discussing the dierence between eective rates and
APRs.
The term should not be confused with simple interest (as
opposed to compound interest) which is not compounded.
The eective interest rate is always calculated as if com-
pounded annually. The eective rate is calculated in the
following way, where r is the eective rate, i the nominal
rate (as a decimal, e.g. 12% = 0.12), and n the number
of compounding periods per year (for example, 12 for
monthly compounding):
r = (1 + i/n)
n
1
3 Examples
1
2 5 EXTERNAL LINKS
3.1 Monthly compounding
Example 1: Anominal interest rate of 6%/a compounded
monthly is equivalent to an eective interest rate of
6.17%.
Example 2: 6% annually is credited as 6%/12 = 0.5% ev-
ery month. After one year, the initial capital is increased
by the factor (1+0.005)
12
1.0617.
3.2 Daily compounding
A loan with daily comp have a substantially higher rate
in eective annual terms. For a loan with a 10% nominal
annual rate and daily compounding, the eective annual
rate is 10.516%. For a loan of $10,000 (paid at the end
of the year in a single lump sum), the borrower would
pay $51.56 more than one who was charged 10%interest,
compounded annually.
4 References
[1] Richard A. Brealey and Steward C. Meyer. Principles of
Corporate Finance, Sixth Edition. Irwin McGraw-Hill,
London, 2000. p. 49.
[2] Charles Moyer, James R. McGuigan, William J. Kret-
low. Contemporary Financial Management, Tenth Edi-
tion. Thomson-South-Western, Mason, Ohio, 2006 pg.
163.
5 External links
Online Nominal Annual Interest Rate Calculator
Online Interest Calculator
3
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