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Kinds of Interest Rates
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Kinds of Interest Rates
Let's say I give you a credit card and the interest rate on the card is 3% per month. What is the annual rate that you are actually charged?? 36%?? Well, no. It's actually 42.57%.
| Nominal Rate | Nominal means "in name only". This is sometimes called the quoted rate. |
| Periodic Rate | The amount of interest you are charged each period, like every month. |
| Effective Annual Rate | The rate that you actually get charged on an annual basis. Remember you are paying interest on interest. |
In the example
- The Nominal Rate is 36%.
- The Periodic Rate is 3% (you are charged 3% interest on your balance every month)
- The Effective Annual Rate is 42.57%
| Nominal Rate = Periodic Rate X Number of Compounding Periods |
| Effective Annual Rate = (1+ i / m)m -1 |
- m = the number of compounding periods
- i = the nominal interest rate
O.K., so let's try the example again.
- Effective Annual Rate = (1+ i / m)m -1
- Effective Annual Rate = ( 1 + .36 / 12 )12 -1
- Effective Annual Rate = (1.03)12 - 1
- Effective Annual Rate = (1.4257) -1
- Effective Annual Rate = .4257
- Effective Annual Rate = 42.57 %