Patrick Louie

Interest is effectively the cost of borrowing money.

For example, you take out a loan of \$120,000 with an annual interest of 10%.

Obviously, since it’s a loan, you will have to repay the \$120,000 eventually.

But on top of paying that, you’d also have to pay the annual interest of 10%, which should amount to \$12,000.

You could consider this annual interest of \$12,000 as the cost of borrowing the \$120,000.

Now just like anything that has to do with money, interest rates are also affected by inflation.

Let’s go back to our example above.

The 10% annual interest rate is the rate that you expect to pay.

But is it the “real” interest that the loan provider earns?

The short answer is no, not really.

We have to consider that the 10% interest rate may be affected by inflation.

To determine the “real interest rate”, we must first take away the inflation component.

This means that the “real interest rate” isn’t necessarily what we see on a loan contract.

Rather, what we see on a typical loan contract is the nominal interest rate.

So, what is this so-called nominal interest rate?

How does one define “nominal interest rate”?

What is its importance in lending?

What is its importance in investing?

Who sets the nominal interest rates?

How does it affect commercial banks?

How does it affect the common person?

We will try to answer these questions as we go along with the article.

## What is the Nominal Interest Rate?

The nominal interest rate refers to the interest rate before adjusting for the effects of inflation.

It can also refer to the stated interest on a loan before adjusting for fees or the compounding of interest.

It’s the rate of interest a borrower pays, or an investor/lender earns.

For example, if the nominal interest rate on a loan is 10%, then that will be the rate of interest that the borrower will pay.

For a more elaborate example, let’s say that you take out a loan of \$10,000 which has a term of three years.

According to the loan agreement, you are to repay the whole principal amount at the end of the term.

Additionally, you will have to pay 9% annual interest.

The 9% annual interest rate is the loan’s nominal interest rate.

This means that for the next three years, you have to make annual interest payments of \$900.

Since the nominal interest does not adjust for the effects of inflation, it cannot be considered the “real” interest rate.

And since it does account for fees or the compounding of interest, it also isn’t the effective interest rate.

## Who Sets the Nominal Interest Rates?

It is the central banks (or the federal reserves in the US) that set the short-term nominal interest rates.

These will then form the basis for the other interest rates that banks and financial institutions charge to their customers.

As such, one can consider the nominal rate as one of the federal reserve’s tools for monetary policy.

The federal reserve may set the short-term nominal interest rates to be low if it wants to stimulate the economy.

Due to the lower cost of borrowing, consumers are incentivized to take out loans and spend money.

However, the federal reserve must be careful in doing so.

It should first gauge whether inflation is a present or a near-term threat. Increasing economic activity may accelerate inflation.

On the other hand, during periods of high inflation, the federal reserve tends to set the nominal interest rates high.

This is to combat or curb the effects of inflation.

With high nominal interest rates, consumers become hesitant to borrow or spend money.

This in turn decreases the money supply, which is one of the ways to deal with inflation.

However, this comes with the risk of overestimating the level of inflation, which can result in setting the nominal interest rates to be too high.

This can further result in the unnecessary stalling of spending.

## Nominal Interest Rate VS Real Interest Rate

Unlike the nominal interest rate, the real interest rate takes the effects of inflation into account.

As such, real interest rates tend to hold more weight to investors and lenders in contrast to nominal interest rates.

Essentially, the nominal interest rate is approximately the sum of the real interest rate and inflation rate.

Put into formula form, it should look like this:

i = R + h

Where:

i – refers to the nominal interest rate

R – refers to the real interest rate

h – refers to the expected inflation rate

We can also present the relationship between the nominal interest rate and the real interest rate via the Fisher Effect:

i = ((1+R) x (1 +h)) – 1

The first formula is more useful in a stable economy that is growing at a moderate pace (i.e. the inflation rate is low).

In a not-so-stable economy where the inflation rate can be inconsistent, the second formula is more appropriate to use.

Investors put more weight on the real interest rate as it can gauge whether or not there is purchasing power erosion.

If the nominal interest rate is lower than the inflation rate, then the real interest rate will be negative.

Let’s put numbers, say the nominal interest rate is 3% while the annual inflation rate is 4%.

This will result in a -1% real interest rate, which effectively erodes the purchasing power of the investors.

Ideally, the nominal interest rate must be higher than the inflation rate.

## Nominal Interest Rate vs Effective Interest Rate (or Annual Percentage Yield)

On a loan contract, the interest rate that you’d see is the loan’s nominal interest rate.

It represents the exact amount of interest that a borrower would pay.

It’s akin to a flat fee that a borrower pays for the service of borrowing money.

However, any experience borrower would know that interest is not the only cost associated with borrowing money.

There may be other fees (e.g. service fee) as well as the compounding of interest.

The nominal interest rate does not account for these factors.

This can be a bit of an issue for borrowers as it does not represent all the costs that they’ll pay when borrowing money.

Thankfully, we have the effective interest rate (or annual percentage yield) for that.

The effective interest rate is essentially a combination of the nominal interest rate, other fees, and the effect of compounding interest.

As such, the effective interest rate is usually higher than the nominal interest rate.

This makes the effective interest rate a more accurate representation of the cost of borrowing, which is why it should be more significant for borrowers (and lenders).

The formula for calculating the effective interest rate is as follows:

e = (1 + i/m)m – 1

Where:

e –  refers to the effective interest rate

i – refers to the nominal interest rate

m – number of compounding periods; for example, if interest is compounded annually, then m = 1

For example, let’s say that a loan has a nominal interest rate of 10%.

The interest is to be compounded semi-annually.

The effective interest rate will then be:

e = (1 + i/m)m – 1

= (1+(0.10/2)2 – 1

= .1025 or 10.25%

As per our calculation, the effective interest rate is 10.25%.

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1. California State University "What is the difference between effective interest rates and nominal interest rates? " Page 1 - 3. August 25, 2022

2. Penn State "Nominal, Period, and Effective Interest Rates" Page 1 . August 25, 2022