Nominal interest rate

From Academic Kids

When comparing interest rates, nominal interest rates and effective interest rates have to be distinguished. An interest rate is called nominal if the period of time after that the interest is credited (e.g. a month) is not identical to the basic time unit (normally a year).

Example

Let's assume an annual interest rate of 6% which is credited after each month. This means that an interest of 6%/12 = 0.5% is credited every month. After one year, the initial capital is increased by the factor (1+0.005)12 ≈ 1.0616. As a result, this nominal interest rate is equivalent to an effective interest rate of 6.16%.

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