julie 474 Nominal vs. Effective Rates of Interest Peter A. Lindstrom A word of warning about Money Market Accounts: Carefully consider @ premature withdrawl of your investment. By permission of Johnny Hart and Field Enterprizes, Inc.21 Thole for Teaching 1987 Invemmonotan Drseuvrion Sues Mosiesearcs int Aurion Fret Prvangursare: UMAP Unit 474 [Nominal ve fectve Rates af Interest Peter A. Lindstrom Math /Tech Division [North Lake College Inving, TX 75038 Mathematics of Finance Banking, busines, and econamics In reading newspapers and magazines, in listening to the radia, and ip watching television, one lien confronted with the terms “compounded daily.” “the effective a nual yield" be rate of nation for last month was” ‘te. Suh items are application of tu forme of interest, the ramial rai andthe afeie rate. The purpest of is module isto 1) introduce these terms, 2) show ow they are wed in banking practices, in dscusing the cate of Snflaton, and in other axpecs of everyone’ ile, and 3} show how these ters are een misused in adertiing and by the media, Student will develop an wackvtand 1 of the term “nominal rate” and “effective rate” and Tearn hw these terms are used in the everyday ie of a Percentages, exponent, solving equations, and haw to we a hand calculator © Copyright (983, 1988 COMAP, Ine. All ight reservedNominal vs. Effective Rates of Interest Peter A. Lindstrom Math/Tech Division North Lake College Irving, TX 75038 Table of Contents L. Inrropvcrion paebe 2, Noumat, Rare ax Erreonive Rare 2.1 Definitions, Formulas, and Review 22 Effective Rates for Comparison 23 Compounding Daily and Effective Rate 2.4 Compounding Continuously and Effective Rate 25 Nominal and Effective Rates of Inflation 2.6 Nominal and Effective Rates in Other Areas Concuston ae fe Mover Exam 0... ‘ANSWERS TO EXERCISES Awswens ro Monet. Exam B 23 23 25 28a Tool fr Teaching 1987 “Mopiites avo Monocnaris n UNDERGRADUATE Martemaries av Irs Aveuications (UMAP) Paoyecr “The goal of UMAP was to develop, through a community of users an developers, a system af instructional modules in undergraduate mathemati and its applicatians to be used to supplement existing courses and fro ‘which complete courses may eventually be bail, “The Project was guided by a National Advisory Beard of mathemat cians, scientist, and educators. UMAP was funded by a grant from National Seienee Foundation and is now supported by the Consortium fe Mathematics and Its Applicatiors (COMAP), Ine. a n¢ engaged in research and development in mathematics education COMAP Stare Paul J. Campbell Editor Solomon A. Garfunkel Executive Director, COMAP Laurie W. Aragon Business Development Manager Philip A. McGaw Production Manager Theresa Cronin Copy Editor Annemarie S. Morgan Administrative Asistant John Gately Distribution “This unit was developed under the auspices of the UMAP Precalculus Panel whose members were: Peter A. Lindstrom (Chair), North Lake Gallege; Charles Biles, Humboldt State University; Marilyn Mays, North Lake College; Roland Lambervon, Humboldt State University; and Richard G. Montgomery, Southern Oregon State College. The Project would like ta thank Dennis R. Adams of che Tennessee State Technical Institute, Martha Kasting of the University of Louisville, Joel Greenstein of New York City ‘Technical College, Harold Baker of Litchfield High School, and Gerald Egerer of Sonoma State University for their reviews, and all athers who assisted in the production ofthis nit. This material was prepared with the partial support of National Scienee Foundation Grants No. SED80-07731 and No. SPE-8304192, Rec: ‘ommendations expressed are those of the author and do not necessarily reflect the views of the NSF or the copyright holder profit corporate1. 21. Nominal, Eve Ralf fats 2 Introduction In reading newspapers and magazines, in listening to the radio, and in watching television, one is often confronted with the terms “compounded daily,” “the effective annual yield,” “the rate of inflation for last month was. ..,” etc, Such items are applications of two forms of interest, the nominal rate and the effective rate. The purpose of this module is to (1) introduce these terms; (2) show how they are used in banking practices, in discussing the rate of inflation, and in other aspects of everyone's life; and (3) show how these terms are often misused in advertising and by the media, ‘As you work through this module, a hand-held calculator will be necessary. Since exponents are involved in many of the calculations, a calculator with an “exponential key” is essential. A Texas Instru- ment SR-50A was used in developing this module; should you use a different calculator, some of your results might differ slightly from what you find here. Nominal Rate and Effective Rate Definitions, Formulas, and Review AA person who invests (borrows) money, receives (pays) intrest on the investment (loan). The money invested (borrowed) is called the principal. ‘The sum of the principal and the intezest is called the ‘ancunt. The rate of interests expressed as a percent of the principal for a specified period of time, where time is measured in years. The rate of interest is expressed asa yearly rate. Throughout this module, ‘wo diffrent types of yearly interest will be discussed. a. Simple Interest: Simple interest is interest paid only on the principal invested (borrowed). For simple interest, the interest period is the length of time for the investment (loan), b. Compound Interest: When the length of time for an invest- ‘ment (loan) is divided into shorter time periods of equal length and when the interest for each time petiod is added to the principal to obtain a new principal for computing the interest for the next period, the interest is called compound interestab Til for Teaching 1987 The basic formula for computing simple interest is: Interest = (Principal) * (Simple interest rate as a decimal) > (Gime expressed in years) I= Prt (a) ‘As you will soon see, (A) can be used for developing other formulas for both simple interest problems and compound interest problems. Example 1. Suppose that you invest $1,000 today for two years. Determine the interest and the amount of your investment if (a) the rate of interest is 8% simple interest and (b) the rate of interest is 8% compounded semiannually. Solution: a. For 8% simple interest, (A) becomes I = ($1,000)(.08)(2), = 8160. Since the amount = principal + interest, then amount = $1,000 + 160, = $1,160. Before solving (b), le’s develop another formula for the amount S: S=P+r =P+ Pe = P+ nt), (B) Notice that (B) yields the amount Sif you know the principal P, the simple interest rate r, and the length of time ¢ expressed in years Using (B) to solve part (a) again, you have 5 = $1,000(1 + (.08)(2)) = $1,160. bb. To solve this problem, recall that the 8% (compounded se annually) is a yearly rate and the total length of the invest-Nominal ws. Efectve Rates of Inmest 27 ment is 2 years or 4 semiannual periods. In (B), the expression t= (08X1/2) = 04 for each semiannual interest period, Considering each half-year interest period, we then have the following amounts: Amount for first half-year= S, = $1,000(1 + 04) = $1,000(1.08) = s1040. S(t + .04) = S1040(1.04) = sto81 60. S(1 + 04) $1081 .60(1.04) = $1124.86, Sy(1 + 04) = $1124.86(1.04) = $1169.85 Hence, you will have $1169.85 for the amount of your investment after two years, and the interest will be $1169.85 — $1,000 = $169.85. ‘The interest and the amount in (b) are both larger than the ‘corresponding items in (a). This should not be surprising, for in (b) both the principal and the interest are camming interest, whereas in (2) only the principal is earning the interest ‘Tracing backward through the computations that produced S,, notice that! S,= (1 + 08), = S(1 + .04)(1 + 04), since $; = 5,(1 + 04), = S\(L + 04)(1 + .04)(1 + 04), ‘S(1 + .04), = $1,000(1 + .04)(1 + .04){1 + .04)(1 + 04), since S, = $1,000(1 + 04), = $1,000(1 + .04)*, Amount for second half-year =. ‘Amount for third half-year = ‘Amount for fourth half-year=28 Tools for Teaching 1987 or, $= $1,000(1 + 00/2)* ¥ ns principal rate per the number of half-year half-year interest periods period ‘This expression can be generalized to the following So o= PL +i)" ~N ney 7 1 \._ interest periods amount principal rate ber selina . period (©) Formula (C) will be used throughout this module. Exercise 1. a, Invest $750 today for 18 months at 7.5% simple interest rate Determine the interest and the amount of this transaction b. Redo Exercise 1(a) using 7.5% compounded quarterly We now come to the two terms that serve as the basis of this module: Nominal rate: The nominal rate, or the nominal annual rate, is that early rate of interest that is compounded more than once per year. This rate is also called the annual interest rat Effective rate: The effective rate or the efectve annual rate is that yearly rate of interest that is compounded only ance per year. This rate is also called the anal equivalent yield. In Example 1(b), the 8% compounded semiannually is « mammal rate, as is the 7.5% compounded quarterly found in Exercise 1(b). ‘The rates in Example 1(a) and Exercise 1(a) are both simple interest rates. (Why is neither one of these an effective rate?) If you invest your money at 10.5% compounded annually, then the 10.5% is an effective rate One last item to consider is the following: Equivalent rates; Two yearly rates of interest are said to be equic- alent if both rates produce the same amount in one year. 42.2 Nominal. Bective Rates of Interest 29 Exercise 2, a, Determine the amount of each of the following investments: (invest $500 for one year at 10.5% effective rate and (i) invest $500 at a 10.5% simple interest rate for one year. Bb, Show that the effective rate is equialent to the simple interest rate for one year. Effective Rates for Comparison In 1969 the US. Federal Government passed the Truth Lending Law. One of the purposes of this law is to let you, the consumer, know exactly what the interest rate is for purposes of ‘making comparisons. By having comparative rates, consumers are able to decide which rate is bes for them. Example 2. If you were to invest $1,000 today for three years, which of the following nominal rales would give you the most money for your investment: 7.85% compounded monthly or 7.9% compounded semi- annually? % compounded monthly rate, after three years you will, $1,000(1 + .0785/12)"* = $1264.57 At the 7.9% compounded semiannually rate, after three years you will have S= P(1 + i)" = $1,000(1 + .079/2)° = $1261.67, Hence, the above calculations indicate that the 7.85% compounded monthly rate yields more money than does the 7.9% compounded semiannually rate. Example 2 shows that the smaller numerical rate produces more money than the larger numerical rate. To some consumers this might bbe surprising as they often feel that the larger the rate, the more money they will have. Example 2 shows you the following: Do not compare the given numerical values of the rates; compare the amounts of money that you would have at the end of the investment period.Tools for Teaching 1987 Another method of comparing rates is to compare the fictive rates for each of these nominal rates; ie, find the effective rate that is equivalent to each of the given nominal rates. Returning to Exan 2, let 1; be the effective rate that is equivalent to the nominal rate of 7.85% compounded monthly. Since both rates will produce the same amount of money in one year, we have the following equation to solve for r, $1,000(1 + 7,/1)' = $1,000(1 + .0785/12)"* at 1 + 0785/12)" (1+ 0785/12)" ~ 1 0814 or 8.14%. (D) Hence, 1, = 8.14% is the effective rate that is equivalent to 7.85% compounded monthly. Let 1, be the effective rate that is equivalent to the nominal rate of 7.9% compounded semiannually. Again, since both rates. will produce the same amount of money in one year, we have the following equation to solve for 1 $1,000(1 + 4/1)! = $1,000(1 + 079, (145) = (1+ 079/27 (1 + 9079/2)" = 1 (0806 or 8.06% (®) Hence, 7, = 806% is the effective rate that is equivalent to 7.9% ‘compounded semiannually ‘You now have two rates, r, and 7, to compare that have the same conversion period; both are compounded only once a year. Since r, > r, after one year you will have more money with the 8.14% effective rate than with the 8.06% effective rate. In terms of the equivalent nominal rates, the 7.85% compounded monthly will, produce more money than the 7.9% compounded semiannually Items (D) and (F) can be generalized to determine the effective rate r% that is equivalent to a nominal rate of " compounded k times per year, where r=(l+j/ky 1 Exercises 3. By comparing effective rates, which of the following nominal rates is, the best for you when you invest your money? ‘a. 9.51% compounded weekly. 'b, 9.52% compounded monthly. ¢. 9.53% compounded quarterly. 623 Nominal os: fective Rte of Interest 34 4, a. In this section, you saw that 7.85% compounded monthly is equivalent to 8.14% compounded yearly. Using the 8.14% effective rate, find the amount you have after 3 years if $1,000 is invested today. Compare the result with that obtained in Example 2 b. Redo (a) using the 8.06% effective rate that is equivalent to 7.9% compounded semiannually. (This fact was also estab- lished in this section.) Compounding Daily and Effective Rate ‘We have just seen that you should compare effective rates and at nominal rates in order to determine the best rate for investing your money. By the Truth-in-Lending Law, banks are required ost both the minal rate and the efecive rate, These rates are often called the annua! rate and the annual yield respectively. Figure 1 shows two bank advertisements that use these terms, Notice that in comparing the two advertisements in Figure 1, the same nominal rates (annual rates) do not produce the same effective rates (annual yields). For example, in one ad, the nominal PAL SAVINGS & LOAN [ANNUAL RATE. "ANNUAL YIELD 800% B¥ear H100minimim 8.33% 775% _Gver H00mimum 8.06% TOK _4¥ear $100 minimum 7.79% “Dies Tranary Rae Gwefate 10.40% 1800minioum 19,965 650% Year 100minimam 6.72% 6.00% 2 Month 100 minima 6.185 ‘aly fo ety wthareal of erties, Paubook Svs rm 550% Pubeak Seine. Paid ham dae of dost dat of wht - ne pray. : Figure 1a,82 Tools for Teaching 1987 ee 8.17% rite 7.75) ‘veka: mgm epost $1000 7.08% vist 6,75% >= 2a ti yeu term minim pea $800 Fats. 6.50% so 02h year ent ia epost $300 eo Figure 1. banks use a ‘year with 360 days, while others use 365 days.” Example 3. SPECIAL TERM SAVINGS ACCOUNTS {At Lion Federal Sovngs,specal erm sigs ‘eowete pay the ghee alowed by aw Invere itpararerd whe Sepost rea 3o ‘tty, ands compounded dy ed ceeded {uate ater us teen depot for Tuyen to ar he high aaa es Show FIC repltions permit wih fom spec fem ngs acoso wit he cae ofthe Back ere matey provided rate of erent or smoun Sternwn reduced to paubook ratte ene ‘St akhdawal nd 3 months terest fosenea rate is 7.75% and its equivalent effective rate is 8.17%, while in the ‘other, the same nominal rate of 7.75% has an effective rate of 8.06%. ‘The reason for this is the manner in which interest is compounded daily. When the nominal rate is compounded daily, some banks use a year with 360 days, while others use 365 days Let’s now consider four possible ways of determining an effective rate + for a nominal race of 7.75% compounded daily. Solution: Case 1: A year with 360 interest periods and a daily rate of 7.15%/ 360. P(L + r/1)' = PC + 075/360)" 14r= (1 + 075/360)" r= (1 + .0775/360) — 1 r= 0806 or 1 = 8.06%. ‘This is called the 360 over 360” method. 8Nominal. Effective Raes of Inrens 39 Case 2: A year with 365 interest periods and a daily rate of 1.79%/365. P(L+ 1/1)! = P(t + 0775 /365) 1 er= (1 + 07757365)" y= (1 + 07757365)" — 1 1= 0806 or r= 8.06%, ‘This is called the “365 over 365” method, Case 3: A year with 365 interest periods and a daily rate of 7.18% /260. PUL + 9/1)! = PCL + 07757360)" 1+ r= (1+ 075/360)" (1 + 075/360) - 1 1 = 0817 or 1 = 8.17%, ‘This is called the “365 over 360” method. Case 4: A year with 360 interest periods and a daily rate of 7.79% /365, P(1 + 1/1)! = P(1 + 075/365) L+r= (1+ 075/365)" r= (1 + .0775/365)°" — 1 1= 0794 or 1 = 7.94%. ‘This is called the 360 over 365” method. Case 3, the "365 over 360” method, shows that the “best™ cffective rate for the investor is obtained when the daily rate is i%/360 and the interest is compounded 365 times per year. All ‘nominal rates compounded daily in this module are done by the “365, over 360” method, or “366 over 360” in leap years, unless stated otherwise. Exercises 5. Verify the other effective rates in Figure 1 6. In Figure 2, the 12% nominal rate compounded daily produces effective annual yields of 12.94% and 12.747%, Determine which of the four cases above produce these different effective rates 9‘Tos for Teaching 1987 ses 295% || au seweeeren || 12.00%, || 38" ' 12.747* 12.0007 | | GFFECTIVE’ANNUAL YIELD. ‘CURRENT RATE OF INTEREST. | arse (30 month, $100 minimum! 7. a Verify that 11.15% is the effective rate that corresponds to 2 10.40% nominal rate compounded daily as shown in Figure 3, (Hint: Be sure to read the fine print in the advertisement.) », Verify that, 11.12% is the effective rate that corresponds 10 10.40% nominal rate compounded daily as shown in the fine print of Figure 3. 8. To answer the following questions, use Figure 4 a Verify that the nominal rate of 8% compounded daily is equivalent to the effective rate of 8.45%. ». Verify that you will have $1,914 at the end of 8 years using the 8% compounded daily rate, «© Verify that you will have $1,914 at the end of @ years using the 8.45% effective rate. Exercises 4 and 8 show that either the nominal rate or the ef fective rate can be used to determine the amount of money that you will have at the end of the investment period. Occasionally, news: Paper advertisements state incorrect rates and, in turn, incorrect vvalucs of money. For example, in Figure 5, the effective rate is stated, 0Nominal vs. Efitice Rates of Inert 38 BFS bedford Federal Savings 11.15% aust perenasesitt — 10.40% sonia ier te 2-1/2 Year or Longer Term Account - Guaranteed" 2 rate higher than anyother commercial bank can pay on 24 10 9 ‘year term accounts opened by January 31 minum depest = 3500. Today, inves aes area an lisime ih. er ‘money mute ese icetanly snp GuesoaMcang ronony. Now sin excelent och up thea ame ph rater aang spoil [A Desf Federal Sanags you are guaranteed she iph teint thw bane far yea ‘Thcrae i per thas ay commer bank can len gay onasvountc of tan ype, A deren Ip oei fee exch moth fre asses The rik mh id sowemeni io iinted ‘caus your depots ae ntl by te IC ap to 64900 for each scount opened in fern epleapey You ca ays whew he interest (2.718281828) — 1), Hence, if the nominal rate J (expressed as a decimal) is compounded continuously, the corresponding equivalent effective rate is (e’ — 1), You should re- member that (¢! — 1) is derived from the “360 over 360” method, not from the “365 over 360” method. Example 5. ‘a, Find the effective rate that corresponds to a nominal rate of 8% compounded continuously, using (¢ — 1). 'b, Round off your result in (a) above to three decimal places and compare that effective rate with the effective rates of Example 4 and Exercise 10. Solution: a. Since the effective rate is given by (¢? ~ 1) for a pounded continuously nominal rate j expressed as a decimal, then for 8%, we have (6 = 1) = (2.718281828 — 1), 1089267068 - 1, 083287068, 832870684. 1b, Rounding to three decimal places, the effective rate is 8.320%, the same effective rate that was obtained in Example 4 and Exercise 10. Example 6. Referring to Figure 7, the advertisement indicates that a 5% nominal ate compounded continuously is equivalent to 5.20% as an effective rate, ‘a. Show that the stated effective rate is incorrect using (e? ~ 1). Indicate how the effective rate might be obtained had the interest been cmpuunded daily. Soluti a. For 5% = .05 compounded continuously, then the correspond ing effective rate is 1 = (2718281828 ~ 1) = 0512710903 or 5.13%, not 5.20%. 15