EFFECTIVE & NOMINAL

INTEREST RATE

TEAM TEACHING
Department of Industrial Engineering
Institut Teknologi Sepuluh Nopember
(ITS)
 COMPOUNDING PERIOD

§ Basically, the interest rate is determined at annual basis

§ But, the compounding frequency can be happened more than 1
times in a year
§ The nominal interest rate is the interest rate that does not
consider the effect of time value of money when the compounding
frequency is happened more than 1 times in a year
§ The effective interest rate is the annual interest rate that consider
the effect of time value of money when the compounding
frequency is happened more than 1 times in a year
§ If the compounding frequency = 1 times per year then the effective
interest rate will be equal with the nominal interest rate

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 NOMINAL INTEREST RATE

• Nominal interest rate per year, r, is the

annual interest rate without considering
the effect of any compounding.
• Example :
The bank pays 2 ½ % interest every 6 months.
The nominal interest rate per year, r, therefore,
is 2 x 2 ½ %= 5%

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 EFFECTIVE INTEREST RATE

• Effective interest rate per year, ia, is the annual

interest rate taking into account the effect of any
compounding during the year
 Example :

• If a savings bank pays 1 ½ % interest every 3

months, what are the nominal and effective
interest rates per year?
Nominal & Effective Interest Rate
Compounding and Payment Period

• Compounding period faster than payment

period

• Payment Period faster than compounding

period

Naning Aranti Wessiani, ST, MM 7

Compounding Period Faster Than
Payment Period

1. Calculate the effective interest rate (ia) per year

or

2. Modify the interest formula by dividing the nominal

interest rate (r) with the number of compounding
period in a year (m) in replacing the i value and
multiply the n period with the m in replacing the n
value
à P = F(P/F, r/m%, Nm)
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Example :

• A man deposits his money in a bank Rp 1

million right now, Rp 3 million 4 years from
now, Rp 1.5 million 6 years from now. The
bank pays 12% per year and compounded
every 6 month.
• How much money that the man will receive
if he withdraw his money 10 years from
now!
Payment Period Faster Than
Compounding Period

• Payment period is adjusted with compounding

period
• For outflow à slower the payment period
• For inflow à faster the payment period
• For outflow and inflow that happen exactly with
the compounding period, no need to adjust
• There will be 2 policy :
1. No interim interest rate or
2. The calculation will be in the form of simple interest
formula 10
Example:

i = 5%

• Based on the cash flow diagram above,

determine the P total if the interest rate 5% / 4
months and compounded every 4 months !
 Continuous Compounding

• It is possible that for some conditions, the

number of compounding period infinite for
a year à continuous compounding
• The effective interest rate per year:
ia = er – 1, where e = 2,71828

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