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How to use effective and nominal interest rates

by Darrell Victor

Knowing the difference between nominal and effective rates can be beneficial in a number of ways. It would help you to compare plans properly and determine what your absolute return is (particularly if you plan to make withdrawals for a specific compounding period). Knowing how and when to apply the knowledge of nominal and effective rates is also useful when you are planning your finances (e.g. retirement planning).

The nominal rate, in simple terms, is the rate of interest for a particular    compounding period. The effective rate of interest (also known as effective annual yield or annualized interest rate) is the interest rate applied per year.

 You can calculate the nominal rate for any number of compounding periods. This can even be calculated for periods of more than a year. In practice, the nominal rates are normally calculated for use in regular modal periods (daily, monthly, quarterly and semi-annually).

Knowledge of the types of rates and how to apply them can help you to accurately determine the absolute returns on investments or savings. 

For example, someone with $1,000,000.00 to invest at 6% per annum may wish to withdraw all the interest compounded monthly at the end of each month. Since the rate is given per annum, the 6% rate is the effective annual rate. The compounding periods per year will be 12 (monthly). Applying this knowledge will prevent you from erroneously believing that $5000.00 is the interest available for withdrawal.

The use of effective and nominal rates would also assist with payment calculations. If you're using a financial calculator, it is important to keep the hidden settings in mind when you are performing calculations. The rate of interest you input would be interpreted by the calculator as either the effective rate or nominal rate, depending on the C/Y settings. If you have your compounding period set to 12, then any rate that you enter would be accepted as the nominal interest. If this is not your intention, the calculation would be misleading.

It is also possible to use interest conversion tables or financial calculators to understand and apply the concept of nominal versus effective interest rates. 

The interest conversion table uses three variables: the effective rate, nominal rate and the compounding period. The compounding period must be entered with either one of the other fields completed. Only then could the interest conversion be facilitated.

When understanding compound interest, the knowledge and application of effective and nominal rates are critical. Their use would help to prevent inaccuracies in financial calculations. Financial calculators are available to do the conversions for us. Still, you must set your calculator properly in order to yield accurate results. Otherwise, your calculations may be misleading. That may have serious repercussions, especially if you're a financial advisor dealing with clients.