Effective and Nominal Interest Rates
Relationship between effective and nominal interest rates
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Interest rate is only meaningful in the context of time - in general is understood as - per year - which may be called
- the nominal interest rate
With other periods of time than year - like month, week, or day - the interest rate may be called
- the effective interest rate
Calculating Nominal Interest Rate
Nominal interest rate for a period with effective interest rates for it's subperiods can be calculated as
i = (1 + ie)n - 1 (1)
where
i = nominal interest rate for the period
ie = effective interest rate for the subperiod
n = number of subperiods
Example - Nominal interest rate with Effective monthly interest rates
Nominal interest rate (per year) with monthly effective rates of 1% can be calculated as
in = (1 + 0.010 )12 - 1
= 0.127
= 12.7%
Calculating Effective Interest Rate
Effective interest rate for the subperiods of a period can be calculated as
ie = (in + 1)1/n - 1 (2)
Example - Nominal interest rate with Effective monthly interest rates
Effective interest rate per month with a nominal rate of 10% can be calculated as
ie = (0.1 + 1)1/12 - 1
= 0.00797
= 0.797%
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Related Topics
- Economics - Engineering economic concepts - cash flow diagrams, discount rate, internal rate of return - IRR, income taxes, inflation
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