The nominal interest rate may be cited in a financial institution advertisement for a loan or deposit. But nominal interest rates provide only rough estimates of how much it costs to borrow money or how much return a deposit will generate. The nominal interest rate is not adjusted for the effects of inflation on purchasing power and does not include additional changes due to fees or compounding.
A financial advisor can help you evaluate interest rates and create a financial plan to help you reach your goals.
Nominal Interest Rate Basics
The nominal interest rate may also be referred to as the advertised interest rate or the stated interest rate. The nominal interest earned on a deposit or paid on a loan is the balance times the nominal interest rate. For instance, a bank may advertise one-year $10,000 personal loans available at a 4% interest rate. The nominal interest for this loan would be $10,000 multiplied by 4%, which equals to $400.
The actual charge for the loan or return on the deposit may be different, because the nominal interest rate does not include other effects such as compounding, fees and discount points that may be part of the transaction. Inflation, which affects the purchasing power of money over time, is also not taken into account by nominal interest rates.
In economics, the nominal interest rate is the rate unadjusted by the effects of inflation. The inflation-adjusted rate is called the real interest rate. To estimate the approximate real interest rate on a loan or deposit, subtract the current or forecast inflation rate from the nominal interest rate. For instance, if a loan offers a 4% nominal interest rate and inflation is 2%, the real interest rate is approximately 2%.
The world of finance has a somewhat different definition. It defines nominal interest as the periodic interest rate times the number of periods in a year. This is relevant because many loans and deposits calculate interest more often than once a year, such as semiannually, quarterly or daily. When this happens, the interest earns interest. This effect, known as compounding, can have a significant effect on the cost of a loan or return on an investment over time. When compounding is included, the interest is known as the effective annual rate (EAR).
Going Beyond Nominal Interest Rates
In addition to considering inflation to get real interest and compounding to get effective interest, nominal interest can also be modified to produce annual percentage interest. For loans, this is called the annual percentage rate (APR). For deposits, its annual percentage yield (APY).
For a loan, the APR includes the effects of compounding. It also includes the impact of fees that may be incurred as part of the cost of taking out the loan. For interest, many mortgage lenders charge a loan origination fee. Other fees such as discount points may be charged as well. The cost of these fees is included in APR to give a figure that is higher than nominal interest and provides a more accurate indicator of the true cost of the loan.
For deposits, APY included the effects of compounding interest. Fees are not usually involved in deposits so APY only reflects compounding. Again, the APY figure will be higher than the nominal interest rate.
While nominal interest rates may appear in financial institution advertisements, APR and APY are often also commonly quoted. The latter two are more accurate and useful for investors and borrowers trying to determine the true interest rate that is being applied. However, neither of these includes inflation, which, especially during periods of high inflation, can have a powerful effect on the real cost of a loan or return on a deposit.
Bottom Line
The nominal interest rate is the most basic way of describing interest charges on a loan and interest payments on a deposit. It is not necessarily the most accurate, however. It doesn’t take into account the effects of inflation, compounding or fees. To accurately estimate the true costs of a loan or return on an investment, investors usually look beyond nominal interest rates. Annual percentage rates on loans and annual percentage yields on investments are more accurate, but they still do not include the impact of inflation on purchasing power.
Interest Rate Tips
- A financial advisor can help you evaluate interest rates and how they affect your savings and investments. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Compound interest can have a profound effect on return on investment over extended periods of time. However, it can be cumbersome to use the formula for calculating compound interest when comparing investments. You can use SmartAsset’s free investment calculator to see quickly, easily and accurately how this type of interest will impact your returns.
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