One of the first topics in the average elementary mathematics curriculum is simple interest. Everyone who went through basic education had to learn this topic. As we grow older and gain more financial literacy, we realize that this subject plays a very important role in our capitalist economies. Therefore, it is important for anyone who intends to have financial dealings to have a good understanding of this subject.
To contribute to this goal, we shall, in this article, be focusing on two interest types – nominal and effective. We will explain what each entails and how they can impact our financial transactions. At the end of this article, you should have a better understanding of how these two interest types operate and how to make the most of either of them.
What is Nominal Interest Rate?
This refers to interest rates indicated on loan and investment contracts without adjusting for compounding. With regards to adjustment for inflation and compounding, nominal interest rate contrasts with the real and effective rates respectively.
Factors that Affect Nominal Rate
Factors that affect this type of rate include Government borrowing and the monetary policy of a country’s financial governing or regulatory body, amongst other factors. By adjusting this factor, apex financial institutions, like the central bank, maintain economies by regulating inflation and recession. Central banks also use it as a short-term tool in the determination of monetary policy. This is normally demonstrated in its reduction and increment during periods of recession and inflation respectively
Effective Interest Rates
Effective Annual Interest Rate (EAR) is a lending rate that has been adjusted to reflect time compounding effects. Summarily, the EAR is the compound lending rate that lenders/borrowers can earn/pay in a year. EAR is used to determine payable earnings on loans, debts and investments like fixed bank deposits and venture capitalist funding. Other names for effective annual interest rates include Annual Equivalent Rate (AER), Effective Rate and Effective Interest Rate (EIR).
In order to calculate the EAR, a number of factors are put into consideration.
These factors include:
- How many times debt is compounded over the space of one year;
- The final amount to be paid.
- The amount of money the investor committed to financing the debt.
To learn more about EAR, visit: https://www.investopedia.com/.
The Fishers Effect
The theory of various natural phenomena existing as metaphors of each other is demonstrated in economic cycles. Like day and night, the economy cycles between periods of growth and periods of recession. As borrowers and investors, financial literacy demands an understanding of the effects of recession on lending rates for risk control.
An economist named Irving Fisher formulated a theory to describe the effect of inflation on both real and nominal lending rates. This theory known as Fisher’s effect explains how the real rate equals nominal rate minus inflation premium. It also implies that nominal lending rate is equal to the sum of the real interest rate and the expected inflation rate (inflation premium).
The consequences of Fishers effect include the following:
- The combination of an increased inflation rate and a constant nominal interest rate will result in reduced real lending rates.
- The combination of an increased inflation rate and corresponding increased nominal interest rates will preserve the real interest rate.
The first scenario will result in the depletion of lenders and investors’ returns owing to a weakening of purchasing power. Knowing this is a step towards financial freedom as it enables the financially literate to do better because they know better. This is one of the many reasons why an understanding of this subject is important.
The Importance of Nominal and Effective Interest
The most important reasons why these two are important include the preservation of value and an understanding of how banks conduct their business. The knowledge of this will guide you on the way and manner to manage risk across both spectrums of the economic cycle.
Let’s briefly break these two benefits down:
Preservation of Value
Preservation of value is among the most important reasons why one should understand the concept of nominell og effektiv rente rates. By taking the inflation premium into consideration, proper measures can be implemented to protect value in spite of economic pressure. Such measures include investing in stable commodities like gold and land to ensure maximal returns above the average market performance.
Bank Loans and Investment Services
Banks hide EAR when lending and display it when advertising for investments. The goal of this documentation is to convince consumers that they are getting the best deal or offer. While it may look deceptive, the aim is to take advantage of gaps in the financial knowledge of their customers to achieve financial goals.
For example, a 20% lending rate for a loan compounded monthly equals an EAR of 22.98%. Nevertheless, commercial banks hide the EIR and advertise the 22% to encourage customers in need of loan services. Awareness of this tactic will help borrower to understand the full extent of deals being offered by banks.
Conversely, Banks advertise EAR instead of stated lending rates with regards to expected returns on fixed deposit accounts.
Before exploring the differences between these two types of rates, it is important to note the factors that determine lending rates in the first place. The three most important factors include:
- Credit score and history,
- Job type/occupation and income level
- Loan amount
Nominal Interest Rates versus Effective Interest Rates
There’s a big difference between these two as explained here. Understanding these differences is pivotal to making informed financial decisions.
Nominal lending rates are unadjusted with respect to inflation and compounding while effective lending rates take compounding into consideration. By taking the compounding effect of time into account, the latter is a better measure of true yield/cost
In conclusion, below is a brief summary of everything you need to know about the differences between the two lending rates we’ve discussed in this article:
The nominal interest rate is the recurring lending rate multiplied by the number of periods in a year. It fails to consider the compounding effect of time. For this reason, two instances of this are not comparable, except they span equal compounding periods.
The EAR is a more accurate tool for measuring actual lending rates. This is because the nominal lending rates and compounding are taken into account when calculating it. Thus, EARs are directly comparable because they have been adjusted to reflect time’s compounding effect.
For example, a compounding period of exactly one year will result in equal nominal and effective rates. So, a 3% annual interest rate bond compounded annually will result in 3% nominal and effective rates (with a periodic rate of 3% and one compounding period per year).
However, compounding periods of less than a year will result in greater EIRs than corresponding nominal interest rates. Thus, the shorter the compounding periods (more compounding periods per year), the greater the EAR will be.
Wrap Up
What we’ve done in this article is provide a very basic explanation of the differences between these two types of lending rates. With this basic introduction, you can now seek a more detailed understanding so you can make your financial decisions from a highly informed standpoint.
Remember that ignorance of a thing does not negate its existence. Same is applicable here. The fact that you do not understand the inner workings of the financial world does not mean that the effects of a wrong decision will not be felt by you. You therefore have two options – improve your financial literacy or run all your transactions through a qualified financial adviser. Needless to say, the former will be a cheaper option.
What did we learn?
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