Written byA nominal rate is the headline annual interest rate a lender quotes before compounding within the year is taken into account, unlike the effective annual rate.
Also known as: nominal interest rate, quoted annual rate, stated rate
Key points
- The periodic rate is the nominal rate divided by the compounding periods per year: 12 for monthly, 26 for fortnightly, 4 for quarterly.
- The effective annual rate (EAR) adds back the compounding, so more frequent compounding pushes it above the nominal rate.
- The National Credit Code requires a comparison rate whenever a rate is advertised for fixed-term consumer credit, and ASIC administers those rules.
- The real rate strips out inflation: exactly, (1 + nominal) / (1 + inflation) minus 1; roughly, nominal minus inflation.
- Two offers with the same nominal rate but different compounding frequencies do not cost the same, so compare on the effective rate.
How a nominal rate works
The nominal rate is the headline percentage in an advert, usually written as a figure per annum. It is the stated interest for a year, not the amount you actually earn or pay once interest is added within the year. Lenders quote it because it is simple, but it can mislead unless you also check the compounding frequency and the fees.
In practice the nominal rate is spread across compounding periods: the periodic rate is the nominal rate divided by m, the number of periods in a year (12 for monthly, 26 for fortnightly, 4 for quarterly). Four figures are worth telling apart: the nominal rate as quoted, the periodic rate applied each period, the effective annual rate after compounding, and the real rate after inflation.
Converting nominal to effective and back
To convert a nominal rate to an effective annual rate, divide the nominal rate by m to get the periodic rate, add 1, raise the result to the power of m, then subtract 1. Written out: EAR = (1 + nominal / m)^m - 1. More frequent compounding lifts the effective rate further above the nominal rate, which is why a rate compounded fortnightly ends up slightly higher than the same rate compounded monthly.
Going the other way, the nominal rate that produces a given EAR is m x ((1 + EAR)^(1/m) - 1). Because different compounding frequencies give different nominal rates for the same EAR, compare advertised nominal rates only when they use the same frequency, or convert everything to EAR. Rounding matters too: lenders may round periodic or nominal rates differently, so check the exact disclosure.
Nominal rate vs APR, comparison rate and real rate
In Australia an annualised percentage rate (APR) is the interest rate disclosed on the credit contract, excluding fees, not a fees-inclusive figure. Usage varies overseas: in the United States the label takes in most compulsory fees, so check what a foreign lender has included. The effective annual rate adds compounding back in, and it is the one to work out for savings and deposits. For loans, the comparison rate is the standardised disclosure that blends interest and most compulsory fees into a single annualised figure. When reading a loan advert, look at the nominal rate, the comparison rate and the compounding frequency together.
The real rate adjusts a nominal rate for inflation. The Fisher relation gives the exact figure, (1 + nominal) / (1 + inflation) - 1, and nominal minus inflation is a reasonable approximation when rates are small. A positive nominal return can be a loss in real terms if inflation runs higher. The ABS publishes Australia's CPI data, and tax can change the net return you keep.
Example
A borrower compares two personal loan offers that advertise the same nominal rate per annum. One charges interest monthly, so m is 12; the other charges fortnightly, so m is 26. Dividing the nominal rate by m gives each loan's periodic rate, and (1 + periodic rate)^m minus 1 gives its effective annual rate. The fortnightly loan comes out slightly higher because interest is added to the balance more often. Each lender's comparison rate then folds in most fees, which can change the ranking again, so the borrower puts those figures side by side before deciding.
Not to be confused with
- Comparison rate
- a comparison rate blends interest and most fees into one annualised figure, while a nominal rate is interest only, before compounding
- Annualised percentage rate (APR)
- in Australia an APR is the interest rate disclosed on the contract, excluding fees, while a nominal rate is the quoted rate before compounding is counted
Frequently asked questions
What is the difference between a nominal and an effective interest rate?
The nominal rate is the headline annual figure a lender quotes. The effective annual rate (EAR) is what you actually earn or pay over a year once interest compounds within the year. Divide the nominal rate by the number of compounding periods, add one, raise it to that power and subtract one to get the EAR.
How does compounding change returns?
Compounding applies interest to interest already earned or charged. The more often it happens within the year, the further the effective annual rate climbs above the nominal rate. Monthly compounding gives a higher effective rate than semi-annual compounding at the same nominal rate, and fortnightly compounding higher still.
Is the nominal rate the same as APR?
Not quite. In Australia an APR is the interest rate a credit provider discloses on the contract, excluding fees, while a nominal rate is the quoted rate before compounding within the year is counted. The figure that adds most compulsory fees is the comparison rate. In the United States, APR is defined to include fees.
Which rate should I use to compare savings accounts?
Compare the advertised rate per annum together with how often interest is paid and credited, because two accounts with the same nominal rate pay different amounts if one credits monthly and the other quarterly. Convert both to an effective annual rate to rank them. For loans, use the comparison rate instead, since it also captures most fees.
How do I adjust a nominal rate for inflation?
Use the Fisher relation. The exact real rate is (1 plus the nominal rate) divided by (1 plus the inflation rate), minus 1. For small rates, nominal minus inflation is a close approximation. If inflation is higher than the nominal rate, a positive nominal return is negative in real terms. The ABS publishes Australia's CPI figures.
Related terms
Broader term: Rate
Comparison rate
A comparison rate is a single annual percentage that combines a loan's interest rate with most upfront and ongoing fees to show its ongoing cost more clearly.
Read definitionCompound interest
Compound interest is interest calculated on both the original principal and the interest already added in earlier periods, so balances and debts grow faster than with simple interest.
Read definitionInterest
Interest is the price of using money: what a borrower pays on a loan, or a saver earns on a deposit, expressed as a percentage rate on the principal.
Read definitionRate
A rate is a ratio or charge expressed against a unit, commonly per year, that measures cost, return or proportion; in finance it usually means an interest rate.
Read definitionAnnualised percentage rate (APR)
The annualised percentage rate (APR) is the annual interest rate a credit provider must disclose on regulated consumer credit under the National Credit Code, excluding fees.
Read definitionFixed rate
A fixed rate is an interest rate locked in for a set term, so the rate and usually the repayments do not change until that term ends.
Read definitionGo deeper
Sources
This article is general information only and is not financial advice.