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Nominal interest rate vs effective interest rate by CompareKing PH

What’s the difference between nominal interest rate and effective interest rate? If you are planning for a vacation or a home renovation or even want to buy the latest 32 inch HD TV, but a little bit short of cash, the best thing to do is postpone your plan and save money for whatever plan you have. However, if you really want to push your plan ASAP, then the next thing to do is get a loan.

Getting a loan is not that easy especially non secured loan. Or saving money in your bank does not necessarily get you a high interest. That is why you need to know about the interest rates. Let us test your knowledge about interest rates. Is 15% per annum compounded monthly the same as 15% per year? The answer is NO. The first one is a nominal interest rate while the latter is an effective interest rate. So what’s the difference? Before I proceed, there are terms that you need to familiarize with.

COMPOUNDING “The ability of an asset to generate earnings which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.�

NOMINAL INTEREST RATE It is defined as “The interest rate on an investment or loan without adjusting for inflation. The nominal interest rate is simply the interest rate stated on the loan or investment agreement on a particular compounding period. The compounding period could be daily, weekly, monthly, quarterly or semi-annually.

EFFECTIVE INTEREST RATE “A measure of the time value of money that fully reflects the effects of compounding� is the definition of effective interest rate. These financial terms are very important in order to differentiate nominal interest rate and effective interest rate. Now let me explain the difference between the two interest rates by showing you an example.

A personal loan worth PHP 100,000 payable in one year at 6% per annum or PHP 6000 interest in a year is a perfect example of a nominal interest rate. It means you pay the bank PHP 106,000 at the end of a year. But if it is compounded to semi-annually, the 6% interest will be divided by 2, it means you have to pay 3% or PHP 3,000 on the first 6 months (PHP 100,000 x .03). In the next 6 months, the amount due will be PHP 3,090 (PHP 103,000 x .03). The total amount that you paid for interest is PHP 6,090 or 6.09%. And that’s what is called an effective interest rate.

Not too many people know that there are different interest rates. Banks advertise the nominal interest rate if you are getting a loan because it is lower and the effective interest rate when depositing or investing your money because it is higher. Remember effective interest rate is higher than the nominal interest rate. In short, in loans, get the nominal interest rate, in investing, get the effective interest loan. CompareKing PH News/Blogs “�. Nominal interest rate vs effective interest rate by CompareKing PH. December 6, 2013. CompareKing PH.

Nominal Interest Rate Vs Effective Interest Rate by CompareKing PH