What is Nominal Interest Rate?

The nominal interest rate is like the sticker price on a new computer...

When you see an advertisement for a new PC, laptop, or tablet, you’ll notice that you probably end up paying more by the time you get through check-out. It turns out that the advertised price (nominal rate) doesn’t include the memory upgrade, antivirus software, and warranty that you want. Then, when you get to the end, you might owe more in taxes and shipping costs (fees).

A nominal interest rate is the stated percentage that is applied to a loan or investment. When you decide to lend or borrow money, there may be an interest rate advertised on the deal. However, not all interest rates mean the same thing. You should clarify whether that stated percentage is a nominal interest rate, effective annual rate (EAR), or annual percentage rate (APR). A nominal interest rate is only the stated percentage multiplied by the balance. Or, if you are the lender, it is the stated rate of interest on an investment that you purchase. A nominal interest rate does not account for inflation, discount points, lending fees, or the effects of compounding.

A nominal interest rate is the percentage applied to the balance of a loan or investment. It does not adjust for inflation, compounding, lending fees, or any other factors. It is the simple stated interest rate, without any other considerations.

The nominal interest rate is just the stated interest rate during a period. For example, if a $1,000 bond has a coupon rate of 6% per year, an investor will receive $60 in interest each year. Therefore, the nominal interest rate is 6%.

If you wanted to calculate the interest with quarterly compounding, you would have an effective interest rate. Or, if you wanted to understand how much that interest is worth in inflation-adjusted dollars, you would have the real interest rate.

Or the market value of the bond might change as conditions move. If you pay $900 for that bond, your annual return on investment (ROI) is more than the nominal interest rate. In this case, your simple ROI would be 6.76% ($60 / $900).

In economics, a nominal value is not adjusted for the effects of inflation (the general tendency for prices to increase over time). However, a dollar today won’t go as far in the future. If a candy bar costs a dollar today, you can buy 10 of them with a $10 bill. Fast forward a few years, and that same candy bar might cost $1.11. Now your $10 bill only buys nine candy bars.

Considering the reduction in purchasing power (that $10 bill being worth nine rather than 10 candy bars), you might be interested in knowing how much your future interest payment is really worth. That’s what a real interest rate tells you. To calculate a real interest rate from a nominal one, you need to know the nominal annual interest rate and the expected rate of inflation. From there, it’s a simple process called the Fisher equation:

Real interest rate = (1 + nominal interest rate) / (1 + rate of inflation) – 1

If the nominal interest rate is 6%, and there is 3% inflation expectation, the real interest rate is:

Real interest rate = (1 + .06) / (1 + .03) – 1 = .02913 or 2.91%

If you only need a rough estimate of the real rate, there is a shortcut that you can do in your head. Just subtract the rate of inflation from the nominal interest rate. In the above example 6% – 3% = 3%. That’s not too far away from the technically correct real return of 2.9%

In finance, a nominal interest rate refers to the periodic interest rate times the number of periods in a year. However, that doesn’t account for any compounding. For that, you need to determine the effective rate. It’s easiest to understand the difference with an example.

Assume your bank offers you a $1,000 personal loan. It’s advertised that you will need to pay the money back plus 8% interest at the end of one year. However, there is some fine print that says it will be compounded monthly. While the nominal rate is 8%, you end up paying a little more than the $80 in interest that you assume you will owe.

The compound interest rate formula is:

Interest = Principal x (1 + (annual rate / periods per year)) ^ (periods per year x number of years) - principal

Interest = $1,000 x (1+ (.08 / 12)) ^ 12 - $1,000 = $83

By adding the phrase “compounded monthly,” there are 12 compounding periods rather than one. Consequently, the amount of interest on this loan increases by $3. That means that an 8% nominal interest rate with monthly compounding has an effective annual interest rate of 8.3%.

An annual percentage rate (APR) rolls any costs of borrowing, in addition to the interest payments, into a percentage. That number allows borrowers to get a better idea about how different loans stack up against each other. A nominal interest rate only shows the percentage of interest that is being charged, but ignores all of the other costs.

All of these additional borrowing costs add up, and they end up costing you more than the advertised rate might suggest. To ensure that borrowers understand the actual cost of borrowing money, the bank informs you of the APR. Credit card companies also use the term APR to reflect the total interest rate that will be charged if a borrower carries a balance forward. In the context of credits cards, the APR is the rate charged by the Federal Reserve (called the prime rate) plus an additional rate charged by the company.

To calculate the APR of a loan, you must first add up all of the borrowing costs. Divide those costs by the amount being borrowed to determine the total cost of money as a percentage of the loan amount. Then, divide that number by the number of days between the day you take out the loan and the day it is repaid. Now you have a daily interest rate. Finally, multiply that number by 365 to convert the daily rate into an annual one. The APR formula looks like this:

APR = (((fees + interest) / principal) / days in loan) x 365

Determining the APR is very helpful when comparing options. For example, consider two loans that offer different nominal interest rates. You are going to borrow $30,000 to build a deck in your backyard. One offers an interest rate of 15%, with no closing costs or fees. The other has a lower interest rate of 13%, but has an origination fee of $2,500 and a $20 monthly fee. Both loans have a 10-year term.

The differences in the loan terms make it difficult to figure out which option is better. The nominal interest rates are different, but that doesn’t mean a lot. The APR allows a better comparison. In this example, the fees charged on the second hypothetical loan make it more expensive than the first — despite the lower nominal interest rate.

However, there is also a trade-off in upfront costs versus monthly costs to consider. For instance, the lower interest rate loan might cost $2,500 upfront, but only have a $450 monthly payment. The other loan doesn’t cost anything to close, but might require a $500 monthly payment. Choosing the best option for you might require considering the burden of that $2,500 down payment, even if the APR is lower.