It is the simple rate of interest that does not reflect inflation or compounding.
Nominal interest rate is the rate of interest that has not been adjusted for inflation, fees, or compounding. It refers to the the simple surface-level rate that indicates the rate of earnings if you’re investing, or costs if you’re borrowing.
Nominal interest rates differ from real interest rates and effective interest rates, both of which we’ll discuss below.
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If you have a loan, the nominal interest rate is the basic level of interest that you’ll pay on the amount you borrow, before it has been adjusted for inflation or compounding. If you have a $1,000 loan with 7% interest, then you would pay $70.
Similarly, if you have a bond, the nominal interest rate is basic interest you’ll earn on your deposit before these same adjustments for inflation and compounding. If you have a $1,0000 bond with a 3% interest rate, you’ll earn $30.
However, neither takes into consideration any details regarding how the interest is calculated, including the frequency at which interest is charged.
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Unlike the nominal rate, real interest rate accounts for the effects of inflation — the rate of increase in the costs of goods and services and the resulting decrease of purchasing power.
The US Federal Reserve reports the inflation rate and anticipatory rate, since an accurate figure can only be assessed for a specific amount of time.
If you have a savings account, the real interest rate will give you the true rate of return or how much you’re earning. Inflation takes place over time, so most people don’t necessary experience its effects in a given moment. But real interest rates are important for lenders and investors because they help you to understand the value of your money given the current economic climate.
Nominal interest = real interest + inflation
In most circumstances, you will use the nominal interest rate to calculate the real interest rate. If you have a loan with a 7% interest rate, and the inflation rate is 2%, then you actually pay a 5% real interest rate and the lender receives a 5% interest as well.
If you have a bond that earns 2% interest, and the inflation rate is also 2%, then the real interest rate for your bond is 0%, meaning you’re not really earning or losing any money.
A higher rate of inflation is better for you if you’re borrowing money, but less favorable when trying to earn money on investments.
To calculate your effective annual rate, you need to know the nominal rate and how often your interest is compounded.
Effective annual interest rate = (1 + nominal rate/compounding periods)^(compounding periods) − 1
If your credit card has a nominal APR of 14.99%, and has a 360 day compounding period, the effective APR would be 16.17%. Longer compounding periods yield lower effective rates. A loan with compounded monthly interest has a lower effective rate than one compounded daily. With a savings account, look for an interest rate that is compounded more frequently, like monthly as opposed to annually, to grow your savings more quickly.
If you deposit $1,000 into a high-yield savings account with a 3.75% nominal interest rate, the effective annual rate is 3.801% with quarterly compounding, and 3.815% with monthly compounding.
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