Since interest rate can take numerous forms, getting familiar with their distinctive features not only helps you distinguish between them, but also gives you a handy guide in the financial world. Besides, as you can estimate the most prevailing interest rates with this interest rate calculator, it is essential to know what their effect is on your personal finance.
The calculator has been designed to estimate bank interest rates on a loan or deposit, so we focus on the following most frequently used rates in such financial transactions:
- Nominal Annual Interest Rate
r - Periodic Rate
i - Effective Annual Rate
EAR - Annual Percentage Rate
APR
- Nominal Annual Interest Rate
The most common interest rate is a nominal annual interest rate, also known as simple interest (or headline or quoted interest rate). If you hear someone talking about a rate in a conversation related to finance, the person likely refers to a nominal interest rate. It is also the figure that banks often advertise as the interest rate on a financial transaction. From the borrower's perspective, it represents the borrowing cost of the loan for a year, represented as a percentage of the loan amount. From the perspective of the lender or investor (depositor), it defines the interest earned on the transaction over a year. While the nominal interest rate provides a simple option to measure the yearly cost of the loan or earnings on a transaction, two important factors mean that we should often consider other interest rates:
- nominal interest rate doesn't account for the effect of compound interests.
- it also doesn't cover any additional cost beyond the interest, which is especially relevant at mortgage loans.
- Periodic Rate
Before we talk about other rates adjusted by the above factors, it is practical to talk about an interest rate applied over a specific period. Since compounding or interest capitalization generally occurs more often than once a year, it is useful to know the rate that is charged on a loan, or realized on a saving/investment over a specific period covering a compounding interval. This rate is the periodic rate.
The simple way to get the periodic interest rate is the following:
periodic rate = nominal interest rate / number of compounding.
- Effective Annual Interest Rate (EAR)
Going back to the previously mentioned shortages of the nominal interest rate, if we take into account the effect of compounding interest, we obtain the Effective Annual Rate (EAR or EFF%). The concept of EAR is the same as that for the Annual Percentage Yield (APY), however, the latter form is applied mainly on investments or savings account. Since the compounding period may vary in different types of financial instruments, one of the main advantages of the Effective Annual Rate is that the financial products became comparable. For example, while a deposit account (A) with a 10.1 percent nominal interest rate compounded semi-annually may seem to be a better option than a savings account (B) that offers 10 percent compounded monthly, by computing their APY we can perform a precise comparison.
By the following financial formula you can compute the APY or EAR:
EAR = ((1 + periodic rate)number of compounding - 1) * 100
periodic rate (A) = 10.1 / 2 = 5.05% = 0.0505
periodic rate (B) = 10 / 12 = 0.83% = 0.0083
APY (A) = ((1 + 0.0505)2 - 1) * 100 = 0.1036 = 10.36%
APY (B) = ((1 + 0.0083)12 - 1) * 100 = 0.1047 = 10.47%
As you can see, the APY for option B with a lower nominal interest rate is around 0.11 percentage point higher than for the option A offering higher nominal rate. While the difference seems to be minor, if the underlying values are high and the transaction is considered over a considerable interval, the difference in interest earnings might become ample.
- Annual Percentage Rate (APR) - APR vs interest rate
Stepping forward, you may find yourself in a situation where the second point is relevant: there are additional costs connected to the loan besides interest that increase your final expense. Since banks are profit-oriented, they aim to maximise their financial gain by obtaining low-cost funds (deposits) and lending out money as expensively as possible (loans). Highly simplifying their operation, the difference between the two transactions is their profit. To acquire more income, however, they might provide other services that they additionally charge to the borrower.
APR is aimed at imparting and pointing out these fees and expressing them in the yearly rate. Therefore, APR might be a better measure when you are about to evaluate the real cost of borrowing or want to compare different loan offers.
Note that the altering the buying power of the money also affects the real value of the interest you pay or receive, especially over a long period. When you adjust the nominal rate by inflation, you get to the concept of the real interest rate, which is an important measure in economics. Our Fisher equation calculator will assist you in this computation. We also recommend our Taylor rule calculator for a deeper dive into inflation, interest rates, and central bank policies.
To conclude, the table below sums up the main peculiarities of the interest rates mentioned above:
