Chapter 2

Nominal and Effective Interest Rates

Engineering Economy
By: Leland Blank . Anthony Tarquin

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 Annual Percentage Rate (APR)
The term APR (Annual Percentage Rate) is often stated as
the annual interest rate for credit cards, loans, and house
mortgages. This is the same as the nominal rate.
For Example: An APR of 15% is the same as a nominal 15%
per year or a nominal 1.25% on a monthly basis.
APY (Annual Percentage Yield) is a commonly stated
annual rate of return for investments, certificates of
deposit, and saving accounts. This is the same as an
effective rate.

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The effective rate is always greater than or equal to the
nominal rate, and similarly APY ≥ APR.
An effective rate can be determined from a nominal rate
by using the relation

Assume r = 9% per year, compounded monthly; then m =

12. Above Equation is used to obtain the effective rate of
9%/12 = 0.75% per month, compounded monthly.

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Example: Three different bank loan rates for electric
generation equipment are listed below. Determine
the effective rate on the basis of the compounding period
for each rate.
(a) 9% per year, compounded quarterly.
(b) 9% per year, compounded monthly.
(c) 4.5% per 6 months, compounded weekly.
Solution
Apply Equation discussed previously to determine the
effective rate per CP for different compounding periods.

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Solution
Apply Equation discussed previously to determine the
effective rate per CP for different compounding periods.

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Various Ways to Express Nominal and Effective Interest
Rates

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 Future Worth
The future worth F at the end of 1 year is the principal P plus the
interest P(i) through the year. Since interest may be compounded
several times during the year, use the effective annual rate
symbol ia to write the relation for F with P = $1.

The effective rate i per CP must be compounded through all m

periods to obtain the total effect of compounding by the end of
the year. This means that F can also be written as

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 Equate the two expressions for F and solve for ia. The effective
annual interest rate formula for ia is

This Equation calculates the effective annual interest rate ia

for any number of compounding periods per year when i is the
rate for one compounding period.

As an illustration, take nominal rate of 18% per year for different

compounding periods (year to week) to determine the effective
annual interest rate. In each case, the effective rate i per CP is
applied m times during the year.

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 Equivalence Relations: Payment Period
and Compounding Period
The payment period (PP) is the length of time between cash
flows (inflows or outflows). It is common that the lengths of
the payment period and the compounding period (CP) do not
coincide. It is important to determine if

PP= CP,

PP >CP, or

PP <CP.

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Illustration:
If a company deposits money each month into an account that
earns at the nominal rate of 8% per year, compounded
semiannually, the cash flow deposits define a payment period of
1 month and the nominal interest rate defines a compounding
period of 6 months. These time periods are shown below.

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 Equivalence Relations: Single Amounts with
PP ≥ CP
Virtually in all situations, PP will be equal to or greater than CP.
The length of the PP is defined by the interest period in the stated
interest rate. If the rate is 8% per year, for example, PP = CP = 1
year. However, if the rate is 10% per year, compounded quarterly,
then PP is 1 year, CP is 1 quarter or 3 months, and PP > CP.

When only single-amount cash flows are involved, there are two
equally correct ways to determine i and n for P/F and F/P factors.

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Method 1: Determine the effective interest rate over the
compounding period CP, and set n equal to the number of
compounding periods between P and F. The relations to
calculate P and F are

For example, assume that the stated credit card rate is nominal
15% per year, compounded monthly. Here CP is 1 month. To
find P or F over a 2-year span, calculate the effective monthly
rate of 15%/12 =1.25% and the total months of 2(12) = 24.
Then 1.25% and 24 are used in the P/F and F/P factors.

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 Method 2: Determine the effective interest rate for the time
period t of the nominal rate, and set n equal to the total
number of periods, using this same time period.
The P and F relations are the same as in Equations discussed
with the term effective i% per t substituted for the interest
rate. For a credit card rate of 15% per year, compounded
monthly, the time period t is 1 year. The effective rate over 1
year and the n values are

The P/F factor is the same by both methods: (P/F,1.25%,24) =

0.7422 using Table 5 given in the book; and (P/F,16.076%,2) =
0.7422 using the P/F factor formula.
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Equivalence Relations: Series with PP≥ CP
When cash flows involve a series (i.e., A, G, g) and the
payment period equals or exceeds the compounding period
in length. PP is now defined by the length of time between
cash flows. This also establishes the time unit of the effective
interest rate.
For example, if cash flows occur on a quarterly basis, PP is 1
quarter and the effective quarterly rate is necessary. The n
value is the total number of quarters. If PP is a quarter, 5
years translates to an n value of 20 quarters.

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