NOMINAL RATE: CHARACTERISTICS AND EXAMPLES - ECONOMY - 2025

The nominal rate refers to the interest rate before inflation is taken into account. It can also refer to the declared interest rate on a loan, without taking into account any charges or compound interest.

Finally, the federal funds rate, which is the interest rate established by the Central Bank of each country, can also be referred to as a nominal rate.

Source: pixabay.com

The nominal interest rate, also called the annualized percentage rate, is the annual interest paid on debt or received for savings, before accounting for inflation. Nominal interest rates exist in contrast to real interest rates and effective interest rates.

It is important to know the nominal interest rate of credit cards and loans, in order to identify the lowest cost ones. It is also important to distinguish it from the real rate, which explains the erosion of purchasing power caused by inflation.

characteristics

In both finance and economics, the nominal rate is defined in one of two ways:

- It is the interest rate before adjusting for inflation, in contrast to the real interest rate.

- It is the interest rate as it was established, without the adjustment for the total effect of capitalization. It is also known as the nominal annual interest rate.

An interest rate is called nominal if the compounding frequency (for example, one month) is not equal to the basic unit of time in which the nominal rate is quoted, usually one year.

Central bank rate

Central banks set the short-term nominal rate. This rate is the basis for the other interest rates charged by banks and financial institutions.

Nominal rates can remain artificially low after a major recession. This stimulates economic activity through low real interest rates. This encourages consumers to borrow and spend money.

On the contrary, during inflationary times, central banks tend to set high nominal rates. Unfortunately, they can overestimate the level of inflation and keep nominal interest rates too high.

The resulting high level of interest rates can have serious economic repercussions. This is because they tend to curb spending.

Difference with real interest rate

Unlike the nominal rate, the real interest rate takes into account the inflation rate. The equation that links the nominal and real interest rates can be approximated as: nominal rate = real interest rate + inflation rate, or nominal rate - inflation rate = real rate.

To avoid the erosion of purchasing power through inflation, investors consider the real interest rate, rather than the nominal rate.

For example, if the nominal interest rate offered on a three-year deposit is 4% and the inflation rate in this period is 3%, the investor's real rate of return is 1%.

On the other hand, if the nominal interest rate is 2% in an environment of annual inflation of 3%, the investor's purchasing power erodes 1% every year.

Difference with effective rate

An interest rate takes two forms: nominal rate and effective rate. The nominal rate does not take into account the compounding period. The effective rate does take into account the compounding period. Therefore, it is a more accurate measure of interest charges.

Although the nominal rate is the rate that is established associated with a loan, it is generally not the rate that the consumer ultimately pays. Instead, the consumer pays an effective rate, varying according to the nominal rate and the effect of compounding.

Stating that the interest rate is 10% means that the interest is 10% per year, compounded annually. In this case, the nominal annual interest rate is 10%, and the effective annual interest rate is also 10%.

However, if compounding is more frequent than just once a year, then the effective rate will be greater than 10%. The more frequent the compounding, the higher the effective interest rate.

Compounding periods

Keep in mind that for any interest rate, the effective rate cannot be specified without knowing the compounding frequency and the nominal rate.

Nominal interest rates are not comparable unless their compounding periods are the same; Effective interest rates correct this by "converting" nominal rates to annual compound interest.

In many cases, the interest rates quoted by the lenders in the advertisements are based on nominal interest rates, not effective. Therefore, they may underestimate the interest rate compared to the equivalent effective annual rate.

The effective rate is always calculated as compounded annually. It is calculated as follows: r = (1 + i / n) n -1.

Where r is the effective rate, i the nominal rate (in decimal, for example: 12% = 0.12), and n the number of compounding periods per year (for example, for a monthly compounding it would be 12):

Examples

The coupons that bond investors receive are calculated using a nominal interest rate, because they measure the bond's percentage yield based on its face value.

Therefore, a 25-year municipal bond with a face value of $ 5,000 and a coupon rate of 8%, paying interest each year, will return to the bondholder $ 5,000 x 8% = $ 400 per year for 25 years.

Monthly compounding

A nominal interest rate of 6% compounded monthly is equivalent to an effective interest rate of 6.17%.

The 6% per year is paid as 6% / 12 = 0.5% each month. After one year, the starting capital is increased by the factor (1 + 0.005) ^ 12 ≈ 1.0617.

Daily compounding

A daily compound loan has a much higher rate in effective annual terms. For a loan with a 10% APR and daily compounding, the effective APR is 10.516%.

For a $ 10,000 loan, paid at the end of the year in a single lump sum, the borrower would pay $ 51.56 more than someone charged 10% compounded interest annually.

References

1. Investopedia (2018). Nominal Interest Rate. Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2018). Nominal interest rate. Taken from: en.wikipedia.org.
3. Oxford University Press (2018). Nominal and Effective Interest. Taken from: global.oup.com.
4. My Accounting Course (2018). What is a Nominal Interest Rate? Taken from: myaccountingcourse.com.
5. Eric Bank (2018). How to Find "Nominal" Interest Rate. Badcredit. Taken from: badcredit.org.