Nominal Interest Rate Definition
In finance and economics, the Nominal Interest rate refers to the interest rate without the adjustment of inflation. It is basically the rate “as stated”, “as advertised” and so on which does not take inflation, compounding effect of interest, tax, or any fees in the account.
It is also known as Annualized Percent Rate. This is the interest compounded or calculated once in a year.
Mathematically, it can be calculated using the below formula is represented as below,
- Real Interest RateReal Interest RateReal interest rates are interest rates calculated after taking inflation into account. It is a means of obtaining inflation-adjusted returns on various deposits, loans, and advances, and thus reflect the real cost of funds to the borrower. is the interest rate that takes inflation, compounding effect, and other charges into account.
- Inflation is the most important factor that impacts the nominal interest rate. It increases with inflation and decreases with deflationAnd Decreases With DeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy..
Nominal Interest Rate Example
Let us assume that the real interest rate of investment is 3% and the inflation rate is 2%. Calculate the Nominal Interest Rate.
Therefore, it can be calculated using the formula as below,
Nominal interest rate formulaNominal Interest Rate FormulaNominal Interest rate refers to the interest rate without the adjustment of inflation. It is a short term interest rate which is used by the central banks to issue loans. = [(1 + 3%) * (1 + 2%)] – 1
So, the Nominal rate will be –
Nominal rate = 5.06%
- It is widely used in banks to describe interest on various loans.
- It is widely used in the investment field to suggest investors for various investment avenues present in the market.
- For example, Car loans available at 10% of the interest rate. This face an interest rate of 10% is the nominal rate. It does not take fees or other charges in an account.
- Bond available at 8% is a coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond's face value by the bond's issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100% as it does not consider current inflation This face interest of 8% is the nominal rate.
Calculate Effective Interest Rate from Nominal Rate
The effective interest rateEffective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period. is the one that caters to the compounding periods during a loan payment plan. The effective interest rate is calculated as if compounded annually, half-yearly, monthly, or daily. On the other side, the stated or nominal rate is less than the effective interest rate. It is the interest rate where interest is calculated only once a year.
The formula for the effective interest rate:
- r the nominal rate (as a decimal),
- and “m” the number of compounding periods per year.
A company XYZ made an investment of Rs.250000 at interest 12% compounded quarterly, calculate the annual effective interest rate.
In the example, investment is made with a nominal rate with 12% compounded quarterlyCompounded QuarterlyThe compounding quarterly formula depicts the total interest an investor can earn on investment or financial product if the interest is payable quarterly and reinvested in the scheme. It considers the principal amount, quarterly compounded rate of interest and the number of periods for computation..
- r = 0.12
- m= 4
Effective Interest Rate = (1 + r/m)^m – 1
- =(1+0.12/4)^4 – 1
- =12.55 %
- The nominal rate does not consider inflation and hence cannot be treated as a true indicator of the cost of borrowing or investment.
- It is not a lucrative option in this regard as inflation is inevitable.
- Now, we know that the Nominal rate does not consider inflation. So to avoid purchasing power erosion through inflation, investors must not consider the nominal interest rate stated by bankers or other, rather, they must keep real interest rate in mind to do the actual valuation of investment and return on investment.
- By considering the real interest rate, they will come to know if they are gaining or losing over the time period. It helps an investor to decide whether to choose saving instruments like fixed deposits, pension funds, or investment instruments like shares, mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc, etc.
- Also, at the time of assessing the cost of borrowing, a borrower must not consider the nominal rate levied by the lender rather, they must consider the effective interest rates. An effective interest rate gives a clear picture when interest is compounding multiple periods in a year. If a person owes $20000 at 20% p.a, he will pay Rs.4000 as interest. If he owes the same $20000 on a credit card which is compounded daily, the effective rate of interest will be 22.13%. He will have to pay $.4426 as interest.
After reading about the nominal interest rate, we can conclude that nominal interest is a stated interest rate, therefore, is a catchy term and it can deceive borrower or investor as it does not give the true picture of the cost of borrowing or net return from an investment.
As it does not consider inflation, tax, investment fees, compoundingCompoundingCompounding is a method of investing in which the income generated by an investment is reinvested, and the new principal amount is increased by the amount of income reinvested. Depending on the time period of deposit, interest is added to the principal amount. effect of interest, we must use alternate interest rate like real interest rate or effective interest rate for actual assessment of our cost of borrowing or investment as and where suited.
This has been a guide on what is Nominal Interest Rate, its definition, significance & applications. Here we also discuss how to calculate using formula and examples. You may learn more about Economics from the following articles –