Understanding Customer Service

Nominal interest rate

In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation (in contrast with the real interest rate); or, for interest rates "as stated" without adjustment for the full effect of compounding (also referred to as the nominal annual rate). An interest rate is called nominal if the frequency of compounding (e.g. a month) is not identical to the basic time unit (normally a year).

versus real interest rate

The real interest rate includes both inflation and the real rate of interest. In the case of a loan, this real interest the lender receives as income. If lender is receiving 8 percent from a loan and inflation is 8 percent, then the real rate of interest is zero because nominal interest and inflation are equal. A lender would have no net benefit from such a loan because inflation fully diminishes the value of the loan's profit.

The relationship between real and nominal interest rates can be described in the equation:

(1 + r)(1 + i) = (1 + R) where r is the real interest rate, i is the inflation rate, and R is the nominal interest rate.[1]

A common approximation for the real interest rate is:

real interest rate = nominal interest rate - expected inflation

In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected losses due to inflation. Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real interest rates may be different; the premium paid to actual inflation may be higher or lower. In contrast, the nominal interest rate is known in advance.

versus effective interest rate

The real interest rate includes both inflation and the real rate of interest. In the case of a loan, this real interest the lender receives as income. If lender is receiving 8 percent from a loan and inflation is 8 percent, then the real rate of interest is zero because nominal interest and inflation are equal. A lender would have no net benefit from such a loan because inflation fully diminishes the value of the loan's profit.

The relationship between real and nominal interest rates can be described in the equation:

(1 + r)(1 + i) = (1 + R) where r is the real interest rate, i is the inflation rate, and R is the nominal interest rate.[1]

A common approximation for the real interest rate is:

real interest rate = nominal interest rate - expected inflation

In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the expected losses due to inflation. Since the future inflation rate can only be estimated, the ex ante and ex post (before and after the fact) real interest rates may be different; the premium paid to actual inflation may be higher or lower. In contrast, the nominal interest rate is known in advance.

Nominal versus effective interest rate

The nominal interest rate is the periodic interest rate times the number of periods per year. For example, a nominal annual interest rate of 12% based on monthly compounding