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What Is the Difference between Effective and Nominal Interest Rates?

Effective interest rates reflect the true cost of borrowing, accounting for compounding within the year, while nominal rates are the stated rates without such considerations. Understanding this distinction is crucial for accurate financial planning. Curious about how this impacts your investments or loans? Dive deeper to see how these rates can shape your financial journey.
G. Wiesen
G. Wiesen

While both effective and nominal interest rates are commonly considered with regard to a loan or other type of payment, the two are quite different. A nominal interest rate is quite simple and is the interest rate for a loan that accrues on a yearly basis. In contrast to this, however, an effective interest rate refers to one in which interest is accrued on a basis other than annually, such as a monthly or weekly basis. Both effective and nominal interest rates are often provided to someone who is taking out a loan that accrues interest, and the interest values can be quite different over an extended period of time.

It is typically easiest for someone to understand the difference between effective and nominal interest rates by first considering each term independently. The simplest form of interest rate is a nominal rate, sometimes also called an annual percentage rate (APR). A nominal interest rate is accrued on a yearly basis, so the interest only has to be calculated a single time at the end of a one year period. This means that a loan of $100 US Dollars (USD) with a nominal interest rate of 15% would accrue $15 US Dollars (USD) of interest in one year.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

In contrast to a nominal interest rate, effective interest rates are determined by utilizing an interval for interest other than one year and adjusting the rate accordingly. Interest accrues on the existing value of a loan, which means that a loan accruing interest each month, that goes unpaid, continues to accrue additional interest based on the previous gain. An initial loan of $100 US Dollars (USD) with a 15% interest rate that accrues twice a year does not have an effective annual rate of 15%.

The accurate effective interest rate can be calculated through the use of a simple formula that adjusts the amount based on how often interest accrues each year. After the first six months, the loan value increases from $100 to $115 US Dollars (USD) due to interest accrual. In another six months, at the end of one year, the second interest accrual is based on $115 US Dollars (USD), not on the original value. When the original 15% is adjusted based on interest accruing twice a year, the effective interest rate becomes 15.56%.

Both effective and nominal interest rates can be used to determine the interest owed on a loan over the course of a year, but effective rates can also be determined over different time periods. If a loan accrues interest on a yearly basis, then the effective and nominal interest rates are the same. Any other time period in which interest accrues, however, creates different interest rates on the same initial loan. This distinction is important since two effective interest rates can easily be compared, but two nominal rates typically have to be adjusted to a common interest interval period to guarantee an accurate comparison.

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