Nominal interest rates accrue annually, while effective interest rates accrue on a non-annual basis. Effective rates can be calculated using a formula that adjusts the amount based on how often interest is earned each year. Different time periods in which interest accrues create different interest rates on the same initial loan.
While nominal and effective interest rates are commonly considered with respect 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 on a loan that accrues annually. In contrast to this, however, an effective interest rate refers to one at which interest accrues on a non-annual basis, such as a monthly or weekly basis. Both effective and nominal interest rates are often given to someone applying for an interest-bearing loan, and the interest values can be quite different over an extended period of time.
It is usually easier 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 accrues annually, so interest only needs to be calculated once 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 earn $15 US dollars (USD) in interest in one year.
Unlike a nominal interest rate, effective interest rates are determined by using an interest interval other than one year and adjusting the rate accordingly. Interest accrues on the existing value of a loan, which means that a loan that accrues interest each month, that is not paid, continues to accrue additional interest based on previous earnings. An initial loan of $100 US dollars (USD) with an interest rate of 15% that accrues twice a year does not have an effective annual rate of 15%.
The precise effective interest rate can be calculated by using a simple formula that adjusts the amount based on how often interest is earned each year. After the first six months, the value of the loan increases from $100 to $115 United States Dollars (USD) due to accrual of interest. In another six months, at the end of a year, the second interest accrual is based on $115 US Dollars (USD), not the original value. When the original 15% is adjusted based on interest earned twice a year, the effective interest rate becomes 15.56%.
Both effective and nominal interest rates can be used to determine the interest due on a loan over the course of a year, but effective rates can also be determined over different time periods. If a loan earns interest annually, the nominal and effective interest rates are the same. However, any other time period in which interest accrues 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 generally have to fit a common interest interval period to ensure an accurate comparison.
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