What is the nominal interest rate and how does it affect my money?

Nominal interest rate refers to the rate that doesn’t reflect inflation or take compounding into account.

It’s the simple surface-level rate that specifics the rate of earnings from investing, or costs from borrowing. Real interest rates and effective interest rates both differ from nominal interest rates, and we’ll discuss that below.

The nominal interest rate is the basic level of interest paid on the amount you borrow. For example, if you have a $1,000 loan with 7% interest, then you would pay $70. Likewise, you’ll earn a nominal interest rate on your bond deposit before these same adjustments for inflation and compounding. For example, if you have a $1,000 bond with a 3% interest rate, you’ll earn $30. However, neither actually takes into consideration details regarding how the interest is calculated. That includes the frequency at which interest is charged.

Real interest rates on the contrary account for the effects of inflation, which is the rate of increase in the costs of goods and services and the resulting decrease of purchasing power.

With savings accounts, the real interest rate will give you the true rate of return or how much you’re earning. Inflation takes place over time, so most people don’t necessarily experience its effect at a given moment. But real interest rates are important for lenders and investors. That’s due to them helping you understand the value of your money given the current economic climate. You will most likely use the nominal interest rate to calculate the real interest rate.

Effective Annual Rate

Having a loan with a 7% interest rate, an inflation rate of 2%, results in you paying a 5% real interest rate, and the lender also receives 5% interest. However, if your bond earns 2% interest with an inflation rate of 2% as well, then your real interest rate is 0%.

A higher rate of inflation is better for you if you’re borrowing money. However, it’s less favourable when trying to earn money on investments.

In order to find your effective annual rate, you need to know the nominal rate and how often your interest is compounded.

Effective annual interest rate = (1 Nominal interest rate/compounding periods)^(Compounding periods) – 1

If your credit card has a nominal APR of 14.99% and has a 360 day compounding period, the effective APR would be 16.17%. A loan with compounded monthly interest has a lower effective rate than one compounded daily.

Look for interest rates that are compounded more frequently (monthly instead of annually) in your savings account. That could help you grow your savings quicker