the Difference Between An Effective Interest Rate And Nominal Rate

When I studied business administration, I remember that the study of the subject of financial mathematics explained to me the difference between actual rates and nominal rates, as follows: The nominal rate is a rate while the effective negotiating is that actually charged. In fact, this explanation is correct, however I think that requires a context to understand it. In other words, after that kind of financial mathematics did not understand the difference between those rates. So much so, that while in college working as a business adviser in a bank in my hometown and it was for me a real dilemma to offer customers the CDT’s because to do so was to use a table which according to the frequency that the client took the title had to explain the nominal rate and the effective rate equivalent, despite the perfect handle the conversion formulas, this generated in me a real internal conflict. With the passage of time I knew an easier way to differentiate between the nominal effective rates so if you still have that doubt what is it that you’ll like: What distinguishes an effective rate of a nominal rate of interest is the capitalization. That is, if there is no capitalization of interest the effective rate is equal to the nominal.

In fact, I’ll explain with an example: If you lend a friend $ 1,000 for a month and you charge an interest rate of 3%, after a month you will receive $ 1,030, and you can say to charge an effective rate equivalent monthly at a rate nominal monthly rate of 3%. However, suppose you give a friend the same $ 1,000 but not a month but two months at 3% per month and additionally you say that interest is compounded monthly. This means that after the first month generated $ 30 interest, which if not canceled at that time by the debtor, in addition to capital of $ 1,000 constituency a new capital of $ 1,030 which will be the basis for charging the interests of second month. Thus the interests of the second month will be $ 1,030 * 3% = $ 30.9. Thus, if your friend is satisfied at the end of two months will give you $ 1,060.9 and you can say the following: 1. I paid $ 1000 at a nominal rate of 3% per month compounded monthly in February. I paid $ 1,000 to a bi-monthly effective rate of 6.09%. Note that both expressions are equivalent because in the first saying that every month you charge the 3% interest on capital, but also that each month the interest becomes capital, while the second just how much increased initial capital the whole period taking into account that part of the interest is capitalized and in turn generated more interest. Think about it and I will continue to expand these concepts.