L8: Nominal and Effective Interest Rates

L8: Nominal and
Effective Interest
Rates
ECON 320 Engineering Economics
Mahmut Ali GOKCE
Industrial Systems Engineering
Computer Sciences
www.izmirekonomi.edu.tr
Chapter 3
Understanding Money
Management
Nominal and Effective
Interest Rates
Equivalence Calculations
using Effective Interest
Rates
Debt Management
Focus
1. If payments occur more frequently than
annual, how do you calculate economic
equivalence?
2. If interest period is other than annual,
how do you calculate economic
equivalence?
3. How are commercial loans structured?
4. How should you manage your debt?
Nominal Versus Effective Interest
Rates
Nominal Interest Effective Interest
Rate: Rate:
Interest rate quoted Actual interest
based on an annual earned or paid in a
period year or some other
time period
18% Compounded Monthly
Nominal Interest
interest rate period
Annual
percentage
rate (APR)
18% Compounded Monthly
What It Really Means?

Interest rate per month (i) = 18%/12 = 1.5%
Number of interest periods per year (N) = 12
In words,
Bank will charge 1.5% interest each month on
your unpaid balance, if you borrowed money
You will earn 1.5% interest each month on your
remaining balance, if you deposited money
18% compounded monthly
Question: Suppose that you invest $1 for 1 year
at 18% compounded monthly. How much
interest would you earn?
Solution:
F $1(1 i )12 $1(1 0.015)12
= $1.1956
ia 0.1956 or 19.56%
18%
= 1.5%
Effective Annual Interest
Rate (Yield)
ia (1 r / M ) 1 M
r = nominal interest rate per year

ia = effective annual interest rate
M = number of interest periods per
year
18%
: 1.5%
or
1.5% per month for 12 months
=
19.56 % compounded annually

Practice Problem
If your credit card calculates the interest

based on 12.5% APR, what is your monthly
interest rate and annual effective interest
rate, respectively?
Your current outstanding balance is $2,000
and skips payments for 2 months. What
would be the total balance 2 months from
now?
Solution
Monthly Interest Rate:
12.5%
i 1.0417%
12
Annual Effective Interest Rate:
ia (1 0.010417)12 13.24%
Total Outstanding Balance:
F B2 $2,000( F / P,1.0417%, 2)
$2,041.88
Practice Problem
Suppose your savings account pays 9%

interest compounded quarterly. If you deposit
$10,000 for one year, how much would you
have?
Solution
(a) Interest rate per quarter:
9%
i 2.25%
4
(b) Annual effective interest rate:
ia (1 0.0225) 4 1 9.31%
(c) Balance at the end of one year (after 4 quarters)
F $10, 000( F / P, 2.25%, 4)
$10, 000( F / P, 9.31%,1)
$10, 931
Nominal and Effective Interest
Rates with Different
CompoundingEffective
Periods
Rates
Nominal Compounding Compounding Compounding Compounding Compounding
Rate Annually Semi-annually Quarterly Monthly Daily
4% 4.00% 4.04% 4.06% 4.07% 4.08%
5 5.00 5.06 5.09 5.12 5.13
6 6.00 6.09 6.14 6.17 6.18
7 7.00 7.12 7.19 7.23 7.25
8 8.00 8.16 8.24 8.30 8.33
9 9.00 9.20 9.31 9.38 9.42
10 10.00 10.25 10.38 10.47 10.52
11 11.00 11.30 11.46 11.57 11.62
12 12.00 12.36 12.55 12.68 12.74
Effective Annual Interest
Rates
(9%quarter
First compounded
Base amount
+ Interest (2.25%)
quarterly)
$10,000
+ $225
Second quarter = New base amount = $10,225

+ Interest (2.25%) +$230.06
Third quarter = New base amount = $10,455.06

+ Interest (2.25%) +$235.24
Fourth quarter = New base amount = $10,690.30

+ Interest (2.25 %) + $240.53
= Value after one year = $10,930.83
Why Do We Need an Effective
Interest Rate per Payment
Period? Payment period
Interest period
Payment period
Interest period
Payment period
Interest period
Effective Interest Rate per
Payment Period (i)
i [1 r / CK ] 1 C
C = number of interest periods per

payment period
K = number of payment periods per year
CK = total number of interest periods per
year, or M
r/K = nominal interest rate per
payment period www.izmirekonomi.edu.tr
Payment Period = Quarter
Compounding Period = Month
1st Qtr 2nd Qtr 3rd Qtr 4th Qtr
1% 1% 1%
3.030 %
One-year
Effective interest rate per quarter
i (1 0.01) 3 1 3.030%
Effective annual interest rate
ia (1 0.01)12 1 12.68%
ia (1 0.03030 )4 1 12.68%
Effective Interest Rate per Payment Period
with Continuous Compounding
i [1 r / CK ] 1C
where CK = number of compounding periods

per year
continuous compounding => C

i lim[(1 r / CK ) 1]
C
(e r )1/ K 1
Case 0: 8% compounded quarterly
Interest Period = Quarterly
1st Q
2nd Q 3rd Q 4th Q

1 interest period
Given r = 8%,
K = 4 payments per year
C = 1 interest period per quarter
M = 4 interest periods per year
i [1 r / CK ]C 1
[1 0.08 / (1)( 4)]1 1
2.000% per quarter
Case 1: 8% compounded monthly
Interest Period = Monthly
1st Q
2nd Q 3rd Q 4th Q

3 interest periods
Given r = 8%,
C = 3 interest periods per quarter
i [1 r / CK ]C 1
[1 0.08 / (3)( 4)]3 1
2.013% per quarter
Case 2: 8% compounded weekly
Interest Period = Weekly
1st Q
2nd Q 3rd Q 4th Q

13 interest periods
Given r = 8%,
C = 13 interest periods per quarter
i [1 r / CK ]C 1
[1 0.08 / (13)( 4)]13 1
2.0186% per quarter
Case 3: 8% compounded continuously
Interest Period = Continuously
1st Q
2nd Q 3rd Q 4th Q

interest periods
Given r = 8%,
i er / K 1
e 0.02 1
2.0201% per quarter
Summary: Effective interest rate per
quarter
Case 0 Case 1 Case 2 Case 3
8% 8% 8% 8%
compounded compounded compounded compounded
quarterly monthly weekly continuously
Payments Payments Payments Payments
occur quarterly occur quarterly occur quarterly occur quarterly
2.000% per 2.013% per 2.0186% per 2.0201% per

quarter quarter quarter quarter

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What It Really Means?

r = nominal interest rate per year

19.56 % compounded annually

If your credit card calculates the interest

Suppose your savings account pays 9%

4% 4.00% 4.04% 4.06% 4.07% 4.08%

5 5.00 5.06 5.09 5.12 5.13

6 6.00 6.09 6.14 6.17 6.18

7 7.00 7.12 7.19 7.23 7.25

8 8.00 8.16 8.24 8.30 8.33

9 9.00 9.20 9.31 9.38 9.42

10 10.00 10.25 10.38 10.47 10.52

11 11.00 11.30 11.46 11.57 11.62

12 12.00 12.36 12.55 12.68 12.74

Second quarter = New base amount = $10,225

Third quarter = New base amount = $10,455.06

Fourth quarter = New base amount = $10,690.30

C = number of interest periods per

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

where CK = number of compounding periods

continuous compounding => C

2nd Q 3rd Q 4th Q

2nd Q 3rd Q 4th Q

2nd Q 3rd Q 4th Q

2nd Q 3rd Q 4th Q

2.000% per 2.013% per 2.0186% per 2.0201% per

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