Effective Interest Rate and Nominal Interest Rate

Are you confused what are effective interest rate and nominal interest rate? Read ahead for the solution.

Nominal interest rate, also known as stated interest rate, works according to the simple interest and doesn't take into account the compounding periods.

Whereas effective interest rate caters the compounding periods during a payment plan. It's used to compare the annual interest between loans with different compounding periods like year, month, weeks etc. In simple words, nominal interest rate is always less than effective rate. Also, effective interest rate reflects the true and fair view of financial payments.

The nominal interest rate is the periodic interest rate times the number of periods per year. For example, a nominal annual interest rate of 14% based on quarterly compounding means a 3.5% interest rate per quarter(compounded). A stated interest rate for compounding periods less than a year is always lower than the equivalent rate with annual compounding. Also note that a nominal rate without the compounding frequency is not fully defined: for any interest rate, the effective rate cannot be specified without knowing the compounding frequency an the rate. Although some conventions are used where the compounding frequency is understood, consumers in particular may fail to understand the importance of knowing the effective rate.

Nominal interest rates are not comparable unless their compounding periods are the same; effective rates are the solution to this, as they convert nominal rates into annual compound interest. In many cases, interest rates as quoted by lenders and in advertisements are based on nominal, and not effective interest rates, and hence may understate the interest rate compared to the equivalent effective annual rate.

The effective interest rate is calculated in the following way -

i = (1 + r / m) ^ m - 1

where i is the effective rate, r is the nominal rate, and m is the number of compounding periods per year( in our case 4 for quarters).

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