NOMINAL RATE vs.

EFFECTIVE RATE

NOMINAL RATE is the rate percent quoted when interest is compounded

more than once a year. It is represented by j and the number of times per year
this rate is compounded or the frequency of conversion is represented by m,
where m is assumed to be an integer.

THE EFFECTIVE RATE represented by w is the rate converted annually that

will produce the same amount of interest per year as the given nominal rate
converted m times per year.
𝑗 𝑚
w = (1 + ) - 1
𝑚

Example

1.) Find the effective rate equivalent to 8% compounded semi annually.

Solution: j = 8%

Given: m = 2

Find: w
𝑗 𝑚
w = (1 + 𝑚) – 1

8% 2
= (1 + 2
) -1

W = 1.08160000 – 1

W = 0.0816 x 100

= 8.16% … m = 1
2.) What rate converted quarterly yields the effective rate 8%?
Solution:
Given: w = 8%= 0.08 j = ?
m = 4
Find: j
𝑗 𝑚
w = (1 + 𝑚) - 1
𝑗 4
0.08 = (1 + 4) - 1
𝑗 4
1 + 0.08 = (1 + 4)
𝑗 4
1.08 = (1 + 4)
4 𝑗 4
√1.08 = 4√(1 + )
4
𝑗
4√(1.08)1 = 1 +
4
1
𝑗
(1.08) 4 = 1 +
4
1
𝑗
= (1.08)4 - 1
4
= 1.01942655 -1
= 0.01942655
j = 4(0.01942655)
j = 0.0777062 x 100
j = 7.77%
COMPARISON OF TWO RATES

To compare different varieties of compound interest, compare their

corresponding effective rates

Example

1.) Which is better, to invest at 7% compounded monthly or at 7.5%

compounded semi annually?

Soluti1on:

A. Given: for j = 7%

m = 12

7% 12
Solution: w = (1 + 12
) -1

w = 1.07229008 – 1

w = 0.0723 x 100

w = 7.23% , m = 1

B. Given: j = 7.5%

m = 2

7.5% 2
Solution: w = (1 + 2
) −1
2.) What rate converted monthly is equivalent to 9% compounded quarterly?

Solution:

Given: j = 9%

m = 4

------------- and ---------------

j = ?

m = 12

Find: j for m=12; at 9%, m=4

9% 4
1 + w = (1 + 4
)

And at the unknown rate j, m= 12

𝑗 12
1 + w = (1 + 12)

Since their respective effective rates are equal, equate these two equations.

𝑗 12 9% 4
(1 + 𝑚) = (1 + 4
)

Extract the twelfth root on each side.

𝑗 12 9% 4
12√(1 + ) = 12√(1 + )
12 4

4
𝑗 9% 12
1+
12
= (1 + 4
)
 1
𝑗 1 3
12
= (1 + 2 4 %) - 1

J = 0.089333 x 100 OR = 8.93%

Solve the following problems:

1.) What effective rate is equivalent to 11% compounded quarterly?

2.) Find the nominal rate compounded monthly, when the effective rate is:

a) 7.5% b) 8% c) 8.5% d) 9%

3.) Find the nominal rate (j), compounded quarterly that is equivalent to 8%
effective?

4.) Which gives a better return, 9% converted monthly or 9.5% effective.

5.) Find the effective rate equivalent to 9%

a) annually b) semi-annually c) quarterly d) monthly

6.) What nominal rate compounded semi-annually will yield the effective rate
9%?

7.) An investment company advertised that they are paying 12% compounded
monthly. If an investor transfers P100,000.00 to this investment company from an
investment company which pays 12% compounded quarterly . how much
additional interest a year will he get, if there is any?

8.) If my money is invested at 11.5% compounded quarterly, should I change my

investment to one yielding 11.75 compounded semi-annually?

9.) A Savings and Loan Association is paying 10% interest rate compounded semi-
annually while another Savings and Loan Association is paying 10.5% effective.
With whom should I invest my money?
10.) A lending institution is offering loans at 17.5% compounded quarterly. At
what nominal rate converted monthly could a borrower just as well borrow that
will pay the same amount of interest?

Exercise:

1. Which is better. To invest at 7.5% compounded monthly or at 8 %

compounded semi-annually?
2. What nominal rate compounded semi-annually is equivalent to 11.5%
compounded quarterly?