Nominal Interest Rate Definition Formula Calculation With Examples

Nominal Interest Rate Definition

In finance and economics, the Nominal Interest rate refers to the interest rate without adjusting inflation. It is the rate “as stated,” “as advertised,” and so on, which does not take inflation, compounding effect of interest, tax, or any fees in the account.

It is also known as Annualized Percent Rate. It is the interest compounded or calculated once a year.

Mathematically, it can be calculated using the below formula is represented below,

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Real Interest RateReal Interest RateReal interest rates are interest rates calculated after taking inflation into account. It is a means of obtaining inflation-adjusted returns on various deposits, loans, and advances, and thus reflect the real cost of funds to the borrower. read more is the interest rate that takes inflation, compounding effect, and other charges into account.Inflation is the most important factor that impacts the nominal interest rate. It increases with inflation and decreases with deflationAnd Decreases With DeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more.

Nominal Interest Rate Example

Let us assume that the real interest rate of investment is 3% and the inflation rate is 2%. Calculate the Nominal Interest Rate.

Therefore, it can be calculated using the formula as below,

Nominal interest rate formulaNominal Interest Rate FormulaNominal Interest rate refers to the interest rate without the adjustment of inflation. It is a short term interest rate which is used by the central banks to issue loans.read more = [(1 + 3%) * (1 + 2%)] – 1

So, the Nominal rate will be –

Nominal rate = 5.06%

Applications

It is widely used in banks to describe interest on various loans.It is widely used in the investment field to suggest investors for various investment avenues present in the market.For example, Car loans are available at 10% of the interest rate. This face an interest rate of 10% is the nominal rate. It does not take fees or other charges in an account.Bond available at 8% is a coupon rateCoupon RateThe coupon rate is the ROI (rate of interest) paid on the bond’s face value by the bond’s issuers. It determines the repayment amount made by GIS (guaranteed income security). Coupon Rate = Annualized Interest Payment / Par Value of Bond * 100%read more as it does not consider current inflation. This face interest of 8% is the nominal rate.

Calculate Effective Interest Rate from Nominal Rate

The effective interest rateEffective Interest RateEffective Interest Rate, also called Annual Equivalent Rate, is the actual rate of interest that a person pays or earns on a financial instrument by considering the compounding interest over a given period.read more is the one that caters to the compounding periods during a loan payment plan. The effective interest rate is compounded annually, half-yearly, monthly, or daily. On the other side, the stated or nominal rate is less than the effective interest rate. It is the interest rate where interest is calculated only once a year.

The formula for the effective interest rate:

where,

r the nominal rate (as a decimal),and “m” the number of compounding periods per year.

XYZ invested Rs.250000 at interest 12% compounded quarterly, calculating the annual effective interest rate.

In the example, investment is made with a nominal rate of 12% compounded quarterlyCompounded QuarterlyThe compounding quarterly formula depicts the total interest an investor can earn on investment or financial product if the interest is payable quarterly and reinvested in the scheme. It considers the principal amount, quarterly compounded rate of interest and the number of periods for computation.read more.

r = 0.12m= 4

Effective Interest Rate = (1 + r/m)^m – 1

=(1+0.12/4)^4 – 1=0.12551=12.55 %

Disadvantages

The nominal rate does not consider inflation and hence cannot be treated as a true indicator of the cost of borrowing or investment.It is not a lucrative option in this regard, as inflation is inevitable.

Significance

Conclusion

After reading about the nominal interest rate, we can conclude that nominal interest is a stated interest rate. Therefore, it is a catchy term, and it can deceive borrowers or investors as it does not give the true picture of the cost of borrowing or net return from an investment.

As it does not consider inflation, tax, investment fees, compoundingCompoundingCompounding is a method of investing in which the income generated by an investment is reinvested, and the new principal amount is increased by the amount of income reinvested. Depending on the time period of deposit, interest is added to the principal amount.read more effect of interest, we must use alternate interest rates like real interest rates or effective interest rates for actual assessment of our cost of borrowing or investment as and where suited.