Difference between Nominal & Effective Interest

Nominal Interest rate is also known as the stated interest rate, it is the rate that is notified by the lender to the borrower in the form of annual percentage. The periodic interest rate is calculated by dividing the annual percentage rate by the per year number of billing periods. This rate is the nominal interest rate of each billing period. For instance, in nominal interest rate there is no compounding of interest, so if 18% per year is compounded monthly the nominal interest rate per 2 months will be 3% (18%/12 * 2).

On the other hand, the effective interest rate is defined as the actual rate of interest which is applicable for a stated time period. The compounding of nominal interest rate gives rise to effective interest rate.

Effective rate per CP (Compounding Period) = r% per time period t / m compunding periods per t = r/m

For instance if the rate of interest is 6%, compounded monthly, then the effective rate will be 0.50% per month (6%/12).



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