Question #51389

By using suitable examples, discuss the differences between periodic rate, nominal
rate and effective rate.

Expert's answer

The term “interest rate” is one of the most commonly used phrases in consumer finance and fixed income investments. Of course, there are several types of interest rates: real, nominal, effective, annual and so on.

The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. This type of interest rate is referred to as the coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders. The nominal interest rate is in essence the actual monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them.

One other type of interest rate that investors and borrowers should know is called the effective rate, which takes the power of compounding into account. For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who invests $1,000 in this bond will receive $30 of interest after the first 6 months ($1,000 x .03), and $30.90 of interest after the next 6 months ($1,030 x .03). The investor received a total of $60.90 for the year, which means that while the nominal rate was 6%, the effective rate was 6.09%. Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific time period. Note that the rules pertaining to how the AER on a financial product is calculated and advertised are less stringent than for the annual percentage rate (APR).

Periodic rate is the interest rate charged on a loan or realized on an investment over a specific period of time. Most interest rates are quoted on an annual basis. If the interest on the loan or investment compounds more frequent than annually, the annual interest rate must be converted to a periodic interest rate where interest charged or realized over each compounding period can be calculated. This calculation is made by dividing the annual interest rate by the number of compounding periods.

The nominal interest rate is conceptually the simplest type of interest rate. It is quite simply the stated interest rate of a given bond or loan. This type of interest rate is referred to as the coupon rate for fixed income investments, as it is the interest rate guaranteed by the issuer that was traditionally stamped on the coupons that were redeemed by the bondholders. The nominal interest rate is in essence the actual monetary price that borrowers pay to lenders to use their money. If the nominal rate on a loan is 5%, then borrowers can expect to pay $5 of interest for every $100 loaned to them.

One other type of interest rate that investors and borrowers should know is called the effective rate, which takes the power of compounding into account. For example, if a bond pays 6% on an annual basis and compounds semiannually, then an investor who invests $1,000 in this bond will receive $30 of interest after the first 6 months ($1,000 x .03), and $30.90 of interest after the next 6 months ($1,030 x .03). The investor received a total of $60.90 for the year, which means that while the nominal rate was 6%, the effective rate was 6.09%. Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific time period. Note that the rules pertaining to how the AER on a financial product is calculated and advertised are less stringent than for the annual percentage rate (APR).

Periodic rate is the interest rate charged on a loan or realized on an investment over a specific period of time. Most interest rates are quoted on an annual basis. If the interest on the loan or investment compounds more frequent than annually, the annual interest rate must be converted to a periodic interest rate where interest charged or realized over each compounding period can be calculated. This calculation is made by dividing the annual interest rate by the number of compounding periods.

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