Nominal Interest Rate

Nominal Interest rate refers to the interest rate without adjusting to inflation. It is the rate that is advertised or stated on a loan or investment without taking into consideration any additional fees or compounded interests. The amount helps the authorities to decide on the fee that should be charged on the loans and investments.

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The nominal interest rate can be misleading for those who seek loans or want to invest. This is because these interest rates are simply the mentioned rates and they do not consider any additional charges to be added further to the loans and investments. This lack of detail might affect people, especially borrowers, who may have to repay as per interest rates with added charges.

• The nominal interest rate in finance and economics represents the interest rate without accounting for inflation, compounding effects, taxes, or account fees.
• Also known as the annualized percentage rate, it reflects interest compounded or determined once a year.
• The nominal interest rate serves as a basis for evaluating investments and returns. Still, it must be supplemented with alternate interest rates like real or effective interest rates to assess borrowing costs or appropriate investments. These alternate rates consider factors such as inflation, taxes, and compounding effects.

The Nominal interest rate definition specifies it as a stated interest rate that 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, compounding 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.

The equation for the nominal interest rate that helps calculate it is as follows:

• Real Interest Rate is the interest rate that takes inflation, compounding effect, and other charges into account.
• Inflation is the most important factor that impacts this rate. It increases with inflation and decreases with deflation.

Let us consider the following example to understand how the nominal interest rate is calculated:

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 formula = – 1

So, the Nominal rate will be –

Nominal rate = 5.06%

Nominal interest rates might have some gray shades to them, but they are useful to borrowers and investors in many ways.

Let us have a look at a list of benefits they offer:

• 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 account.
• Bond available at 8% is a coupon rate as it does not consider current inflation. This face interest of 8% is the nominal rate.

The disadvantages of such interest rates must be known to those seeking loan or want to make investments.

Here is a list of demerits associated with these interest rates:

• 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.

The effective interest rate 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 quarterly.

• r = 0.12
• m= 4

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

• =(1+0.12/4)^4 - 1
• =0.12551
• =12.55 %

Also, when assessing the cost of borrowing, a borrower must not consider the nominal rate levied by the lender. Rather, they must consider the effective interest rates. An effective interest rate gives a clear picture of interest compounding multiple periods in a year. If a person owes $20000 at 20% p.a, he will pay Rs.4000 as interest. If he owes the same $20000 on a credit card compounded daily, the effective interest rate will be 22.13%. He will have to pay $.4426 as interest.

As nominal rate does not consider inflation, it is important for investors to act smart and not rely completely on these calculated rates. This means, investors must not consider the nominal interest rate stated by bankers or others to avoid purchasing power erosion through inflation. Rather, they must keep the real interest rate in mind to do the actual valuation of investment and return on investment.

By considering the real interest rate, they will know if they are gaining or losing over the period. It helps an investor decide whether to choose saving instruments like fixed deposits, pension funds, or investment instruments like shares, mutual funds, etc.

This has been a guide on what is Nominal Interest Rate. We explain the concept along with its formula, vs effective and real interest rate, & an example. You may learn more about Economics from the following articles –

• ROI
• Rate of Return Formula
• Formula of Mortgage
• What is Simple Interest?