Nominal and Effective Interest

Rates

Lecture No. 10
Chapter 4
Contemporary Engineering Economics
Copyright © 2006

Contemporary Engineering Economics, 4th

edition, © 2007
Chapter Opening Story – Hybrid Mortgages

 With hybrids, borrowers

choose to accept a fixed
interest rate over a number
of years—usually 3,5,7 or
10 years—and afterward
the loan converts to an
adjustable-rate mortgages.

 Under what situation, would

a homeowner benefit from a
hybrid financing?

Contemporary Engineering Economics, 4th

edition, © 2007
Understanding Money and Its
Management – Main Focus
1. If payments occur more frequently than
annual, how do you calculate economic
equivalence?
2. If interest period is other than annual,
how do you calculate economic
equivalence?
3. How are commercial loans structured?
4. How should you manage your debt?

Contemporary Engineering Economics, 4th

edition, © 2007
Nominal Versus Effective Interest Rates

Nominal Interest Effective Interest

Rate: Rate:
Interest rate quoted Actual interest
based on an annual earned or paid in a
period year or some other
time period

Contemporary Engineering Economics, 4th

edition, © 2007
Financial Jargon
18% Compounded Monthly

Interest
Nominal
period
interest rate
Annual
percentage
rate (APR)
Contemporary Engineering Economics, 4th
edition, © 2007
18% Compounded Monthly

 What It Really Means?

 Interest rate per month (i) = 18%/12 = 1.5%
 Number of interest periods per year (N) = 12
 In words,
 Bank will charge 1.5% interest each month on
your unpaid balance, if you borrowed money.
 You will earn 1.5% interest each month on your
remaining balance, if you deposited money.

Contemporary Engineering Economics, 4th

edition, © 2007
18% compounded monthly

 Question: Suppose that you invest $1 for 1 year

at 18% compounded monthly. How much
interest would you earn?
 Solution:
F  $1(1  i )12  $1(1  0.015)12
= $1.1956
ia  0.1956 or 19.56%

Contemporary Engineering Economics, 4th

edition, © 2007
Effective Annual Interest Rate (Yield)

r M
ia  (1  )  1
M
r = nominal interest rate per year
ia = effective annual interest rate
M = number of interest periods per
year
Contemporary Engineering Economics, 4th
edition, © 2007
What It Really Means

18% compounded monthly

means
1.5% per month for 12 months
or

19.56 % compounded once annually

Contemporary Engineering Economics, 4th
edition, © 2007
Practice Problem

 If your credit card charges the interest based

on 12.5% APR, what is your monthly interest
rate and annual effective interest rate,
respectively?
 Your current outstanding balance is $2,000
and you skip payments for 2 months. What
would be the total balance 2 months from
now?

Contemporary Engineering Economics, 4th

edition, © 2007
 Solution
Monthly Interest Rate:
12.5%
i  1.0417%
12
Annual Effective Interest Rate:
ia  (1  0.010417)12  13.24%
Total Outstanding Balance:
F  B2  $2,000( F / P,1.0417%, 2)
 $2,041.88

Contemporary Engineering Economics, 4th

edition, © 2007
Practice Problem

 Suppose your savings account pays 9%

interest compounded quarterly. If you deposit
$10,000 for one year, how much would you
have?

Contemporary Engineering Economics, 4th

edition, © 2007
Solution
(a) Interest rate per quarter:
9%
i  2.25%
4
(b) Annual effective interest rate:
ia  (1  0.0225) 4  1  9.31%
(c) Balance at the end of one year (after 4 quarters)
F  $10, 000( F / P, 2.25%, 4)
 $10, 000( F / P, 9.31%,1)
 $10, 931

Contemporary Engineering Economics, 4th

edition, © 2007
Effective Annual Interest Rates
(9% compounded quarterly)
Base amount $10,000
First quarter
+ Interest (2.25%) + $225

= New base amount = $10,225

Second quarter
+ Interest (2.25%) +$230.06

= New base amount = $10,455.06

Third quarter
+ Interest (2.25%) +$235.24

= New base amount = $10,690.30

Fourth quarter
+ Interest (2.25 %) + $240.53
= Value after one year = $10,930.83

Contemporary Engineering Economics, 4th

edition, © 2007
Nominal and Effective Interest Rates with
Different Compounding Periods
Effective Rates
Nominal Compounding Compounding Compounding Compounding Compounding
Rate Annually Semi-annually Quarterly Monthly Daily

4% 4.00% 4.04% 4.06% 4.07% 4.08%

5 5.00 5.06 5.09 5.12 5.13

6 6.00 6.09 6.14 6.17 6.18

7 7.00 7.12 7.19 7.23 7.25

8 8.00 8.16 8.24 8.30 8.33

9 9.00 9.20 9.31 9.38 9.42

10 10.00 10.25 10.38 10.47 10.52

11 11.00 11.30 11.46 11.57 11.62

12 12.00 12.36 12.55 12.68 12.74

Contemporary Engineering Economics, 4th

edition, © 2007
Why Do We Need an Effective Interest
Rate per Payment Period?
Whenever payment and compounding periods differ from
each other, one or the other must be transformed so that
both conform to the same unit of time.

Payment period

Interest period

Payment period

Interest period
Contemporary Engineering Economics, 4th
edition, © 2007
Effective Interest Rate per Payment Period
(i)
r C
i  [1  ] 1
CK
C = number of interest periods per
payment period
K = number of payment periods per year
CK = total number of interest periods per
year, or M
r/K = nominal interest rate per
payment period
Contemporary Engineering Economics, 4th
edition, © 2007
Functional Relationships among r, i, and ia, where
interest is calculated based on 9% compounded
monthly and payments occur quarterly

Contemporary Engineering Economics, 4th

edition, © 2007
Effective Interest Rate per Payment Period with
Continuous Compounding
C
 r 
i  1    1
 CK 
where CK = number of compounding periods
per year
continuous compounding => C  
C
 r 
i  lim 1   1
C 
 CK 
 e 
1/ K
r
1
Contemporary Engineering Economics, 4th
edition, © 2007
Case 0: 8% compounded quarterly
Payment Period = Quarter
Interest Period = Quarterly
1st Q

2nd Q 3rd Q 4th Q

1 interest period Given r = 8%,
K = 4 payments per year
C = 1 interest period per quarter
M = 4 interest periods per year
i  [1  r / CK ]C  1
 [1  0.08 / (1)( 4)]1  1
 2.000% per quarter
Contemporary Engineering Economics, 4th
edition, © 2007
Case 1: 8% compounded monthly
Payment Period = Quarter
Interest Period = Monthly
1st Q

2nd Q 3rd Q 4th Q

3 interest periods Given r = 8%,
K = 4 payments per year
C = 3 interest periods per quarter
M = 12 interest periods per year
i  [1  r / CK ]C  1
 [1  0.08 / (3)( 4)]3  1
 2.013% per quarter
Contemporary Engineering Economics, 4th
edition, © 2007
Case 2: 8% compounded weekly
Payment Period = Quarter
Interest Period = Weekly
1st Q

2nd Q 3rd Q 4th Q

13 interest periods Given r = 8%,
K = 4 payments per year
C = 13 interest periods per quarter
M = 52 interest periods per year

i  [1  r / CK ]C  1
 [1  0.08 / (13)( 4)]13  1
 2.0186% per quarter
Contemporary Engineering Economics, 4th
edition, © 2007
Case 3: 8% compounded continuously
Payment Period = Quarter
Interest Period = Continuously
1st Q

2nd Q 3rd Q 4th Q

 interest periods Given r = 8%,
K = 4 payments per year

i  er / K 1
 e 0.02  1
 2.0201% per quarter

Contemporary Engineering Economics, 4th

edition, © 2007
Summary: Effective Interest Rates per Quarter
at Varying Compounding Frequencies

Case 0 Case 1 Case 2 Case 3

8% 8% 8% 8%
compounded compounded compounded compounded
quarterly monthly weekly continuously
Payments Payments Payments Payments
occur quarterly occur quarterly occur quarterly occur quarterly

2.000% per 2.013% per 2.0186% per 2.0201% per

quarter quarter quarter quarter

Contemporary Engineering Economics, 4th

edition, © 2007