What is the difference between nominal, effective and APR interest rates?

Article Category: Finance  |   

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Hi there and welcome back to our bi-weekly look at the world of finance. In this edition, we'll once again be dipping our toes into the murky waters of finance and loans.

We've spoken about a number of different types of interest rates but, judging by the emails we've received, it looks like there's still some confusion. In fact, a number of our regular readers have said that rather than learning about the individual types, they’d like to understand how different types of loan and interest rates compare.

So, this week, we're going to look at the difference between nominal interest rate, effective interest rate and APR.

What Is 'Nominal Interest Rate'?

The simplest explanation of nominal interest rate is this: it's the interest rate before inflation gets added into the mix. It's also the one you're most likely to be exposed to as it's the interest rate lenders commonly quote in loan and deposit agreements. Nominal interest is directly affected by the rate of inflation and can make a big dent in an investor's purchasing power.

Here's an example of the impact inflation has:

Let's say you're offered an interest rate of 5% on a five-year deposit. Now, over the same period, inflation is running at 3%. This means that an investors rate of return is only 2% which, although it's a pretty measly return, still represents a profit. The problem comes when you have an interest rate of 2% over the same period combined with an inflationary figure of 3% - your purchasing power decreases by one percent per annum.

For first time and amateur investors, a simple way to estimate your real rate of return would be to watch the interest rates on Treasury Inflation-Protected Securities (TIPS). By calculating the difference between the yield on Treasury bonds and TIPS you'll be able to estimate inflation expectations in the economy.

Nominal interest rates are set by banks on a short term basis and can be controlled during times of economic hardship to help stimulate economic activity and make your dollars go further.

Nominal interest is the foundation on which other types of interest are calculated, i.e: it's the base rate.

Should you wish to work out the basic percentage interest between a 'before' and 'after' figure, give the percentage calculator a try.

What Is Effective Interest Rate?

The effective rate is the interest you pay on a loan and is also known as annual equivalent rate (AER).

It's also an indication of the true rate of interest that you'll pay on your loans or earn on your savings. Here's a quick example:

You've decided to invest in a $1,000 bond that pays 6% interest. At the end of the first year you'll receive $60. Nice and simple, right? But what if the market interest rates start to creep up to 8%? In this case, nothing! You'll still receive $60 at the end of the year, which makes the bond very unattractive and difficult to sell. In fact, most investors would only pay for a 6% bond in an 8% market if they are paid 8%.

In order to find a representative value for the bond, the investors will discount future cash flows by 8% (which will give them the present value of the bond). With a little clever massaging of the $1,000 investment when it reaches maturity, the original investment will be discounted by 8%. This process results in the investor receiving an exact 8% return over the life of the investment.

Did I mention that this can be a little tricky to understand?

To make matters more complicated, banks vary in what they view as effective annual interest. For example, some banks may talk about the yield on your investments after expected losses are factored in. They may also include income from fees in the calculation. Either way, the net result is that the interest paid may vary significantly from one person to the next.

What Is APR?

Ok, here's where things get a little confusing. APR (aka Annualised Percentage Rate) is a type of interest rate that is calculated over a set period of months (normally twelve). Ok, so far that seems fairly easy to understand. Now let's look at how APR is related to nominal and effective interest rates:

Nominal APR is the simple interest rate you pay over one year. For example, if you're paying 1% interest on a loan every month then your nominal APR is 12%. Effective APR is the amount you pay after fees and compound interest have been added to the charges. E.G: your nominal interest rate may be set at 1% per month but, with fees and charges, your APR might be 17.9%.

APR is a very simple way of letting you compare interest rates from different lenders.

In the United States, the Truth in Lending Act governs how lenders calculate APR and requires all details of non-interest related charges and fees.

Calculating interest rates

Should you wish to work out the interest rate that you are currently paying on your mortgage or loan, give the handy interest rate calculator a try.

That’s all for today. Hopefully you now have a better understanding of nominal vs effective interest vs APR. If you would like to learn more about APR, take a look at our article, what is APR?.

If you have any questions or points then please feel free to email us.

Written by James Redden

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Last update: 06 February 2014

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