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

www.izmirekonomi.edu.tr
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?

www.izmirekonomi.edu.tr
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

www.izmirekonomi.edu.tr
18% Compounded Monthly

Nominal Interest
interest rate period

Annual
percentage
rate (APR)
www.izmirekonomi.edu.tr
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

www.izmirekonomi.edu.tr
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%
www.izmirekonomi.edu.tr
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

www.izmirekonomi.edu.tr
 18%

: 1.5%
18% compounded monthly
or
1.5% per month for 12 months
=

19.56 % compounded annually

www.izmirekonomi.edu.tr
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?

www.izmirekonomi.edu.tr
 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

www.izmirekonomi.edu.tr
Practice Problem

 Suppose your savings account pays 9%

interest compounded quarterly. If you deposit
$10,000 for one year, how much would you
have?

www.izmirekonomi.edu.tr
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

www.izmirekonomi.edu.tr
Nominal and Effective Interest Rates with
Different Compounding Periods
Effective 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

www.izmirekonomi.edu.tr
Effective Annual Interest Rates
(9% compounded quarterly)
Base amount $10,000
First quarter
+ Interest (2.25%) + $225

= New base amount = $10,225

Second quarter
+ Interest (2.25%) +$230.06

= New base amount = $10,455.06

Third quarter
+ Interest (2.25%) +$235.24

= New base amount = $10,690.30

Fourth quarter
+ Interest (2.25 %) + $240.53
= Value after one year = $10,930.83

www.izmirekonomi.edu.tr
Why Do We Need an Effective Interest
Rate per Payment Period?
Payment period

Interest period

Payment period

Interest period

Payment period

Interest period

www.izmirekonomi.edu.tr
Effective Interest Rate per Payment Period
(i)

i  [1  r / CK ]  1C

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
12% compounded monthly
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%
www.izmirekonomi.edu.tr
Effective Interest Rate per Payment Period with
Continuous Compounding

i  [1  r / CK ]  1 C

where CK = number of compounding periods

per year

continuous compounding => C  

i  lim[(1  r / CK )  1]
C

 (e )
r 1/ K
1
www.izmirekonomi.edu.tr
Case 0: 8% compounded quarterly
Payment Period = Quarter
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
www.izmirekonomi.edu.tr
Case 1: 8% compounded monthly
Payment Period = Quarter
Interest Period = Monthly
1st Q

2nd Q 3rd Q 4th Q

3 interest periods Given r = 8%,
K = 4 payments per year
C = 3 interest periods per quarter
M = 12 interest periods per year
i  [1  r / CK ]C  1
 [1  0.08 / (3)( 4)]3  1
 2.013% per quarter
www.izmirekonomi.edu.tr
Case 2: 8% compounded weekly
Payment Period = Quarter
Interest Period = Weekly
1st Q

2nd Q 3rd Q 4th Q

13 interest periods Given r = 8%,
K = 4 payments per year
C = 13 interest periods per quarter
M = 52 interest periods per year

i  [1  r / CK ]C  1
 [1  0.08 / (13)( 4)]13  1
 2.0186% per quarter
www.izmirekonomi.edu.tr
Case 3: 8% compounded continuously
Payment Period = Quarter
Interest Period = Continuously
1st Q

2nd Q 3rd Q 4th Q

 interest periods Given r = 8%,
K = 4 payments per year

i  er / K 1
 e 0.02  1
 2.0201% per quarter

www.izmirekonomi.edu.tr
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

www.izmirekonomi.edu.tr