Nominal interest rate

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In finance and economics, nominal interest rate or nominal rate of interest refers to two distinct things: the rate of interest before adjustment for inflation (in contrast with the real interest rate); or, for interest rates "as stated" without adjustment for the full effect of compounding (also referred to as the nominal annual rate). An interest rate is called nominal if the frequency of compounding (e.g. a month) is not identical to the basic time unit (normally a year).

Nominal versus real interest rate[edit]

The real interest rate is the nominal rate of interest minus inflation. 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 inflation is 8 percent, then the real rate of interest is zero because nominal interest and inflation are equal. A lender would have no net benefit from such a loan because inflation fully diminishes the value of the loan's profit.

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 inflation rate, and R is the nominal interest rate.[1]

  • A common approximation for the real interest rate is:
real interest rate = nominal interest rate - expected inflation

In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected losses due to inflation. Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real interest rates may be different; the premium paid to actual inflation may be higher or lower. In contrast, the nominal interest rate is known in advance.

Nominal versus effective interest rate[edit]

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 example, a nominal annual interest rate of 12% based on monthly compounding means a 1% interest rate per month (compounded).[2] A nominal interest rate for compounding periods less than a year is always lower than the equivalent rate with annual compounding (this immediately follows from elementary algebraic manipulations of the formula for compound interest). Note that a nominal rate without the compounding frequency is not fully defined: for any interest rate, the effective interest rate cannot be specified 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 importance of knowing the effective rate.

Nominal interest rates are not comparable unless their compounding periods are the same; effective 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 effective interest rates, and hence may understate the interest rate compared to the equivalent effective annual rate.

Confusingly, in the context of inflation, 'nominal' has a different meaning. A nominal rate can mean a rate before adjusting for inflation, and a real rate is a constant-prices rate. The Fisher equation is used to convert between real and nominal rates. To avoid confusion about the term nominal which has these different meanings, some finance textbooks use the term 'Annualised Percentage Rate' or APR rather than 'nominal rate' when they are discussing the difference between effective rates and APR's.

The term should not be confused with simple interest (as opposed to compound interest) which is not compounded.

The effective interest rate is always calculated as if compounded annually. The effective rate is calculated in the following way, where r is the effective 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

Examples[edit]

Monthly compounding[edit]

Example 1: A nominal interest rate of 6%/a compounded monthly is equivalent to an effective interest rate of 6.17%.

Example 2: 6% annually is credited as 6%/12 = 0.5% every month. After one year, the initial capital is increased by the factor (1+0.005)12 ≈ 1.0617.

Daily compounding[edit]

A loan with daily comp have a substantially higher rate in effective annual terms. For a loan with a 10% nominal annual rate and daily compounding, the effective 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.

References[edit]

  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. Kretlow. Contemporary Financial Management, Tenth Edition. Thomson-South-Western, Mason, Ohio, 2006 pg. 163.

External links[edit]