There are various kinds of interest rates when it comes to consumer finance and long-term investments. These include nominal interest rates, real interest rates, and effective interest rates. Keep in mind that these differences stem from a few important economic factors. When taking out a loan to buy a car, it’s important to understand these different types of interest rates in order to make more informed financial decisions.
The nominal rate of interest is the simplest kind of interest rate among the three, because it doesn’t take inflation into account. In other words, it’s the rate of interest quoted on a loan or bond. The nominal rate can also be the stated, or advertised as the rate of interest on a loan, before taking into consideration compounding interest or other fees and charges that might affect that final interest rate. It’s the first rate you’ll hear in most cases, since it’s the rate of interest that lenders often mention in deposit and loan agreements. In essence, the nominal rate is the cost that a borrower pays the lender for the ability to use their funds. So, if you take out a loan for a car with a nominal rate of 8 percent, you’ll incur $8 of interest on every $100 that you borrow.
Compared to the nominal rate, the real interest rate is a bit trickier of a concept to explain. Real rates are interest rates that have been adjusted to account for financial ripples caused by inflation. They reflect the real costs associated with borrowing money, representing the real return to an investor or lender. You can figure out the actual rate of interest by deducting the total rate of inflation from the nominal rate. Keep in mind that the nominal rate can be misleading as it does not tell the complete story. This is because inflation considerably reduces the purchasing power of an investor or lender, meaning they can’t purchase the same quantity of services or goods at the time of maturity or payoff with their loan as they can in the present. For example, if a car loan has an 8 percent nominal yield and compounds annually, while the rate of inflation is 3 percent, then the investor will earn a real rate of only 5 percent. In other words, the real rate is the actual rate at which lenders and investors are increasing their purchasing power by lending funds. Also, it’s important to bear in mind that real interest rates can be negative in cases where the rate of inflation is greater than the nominal rate offered by an investment. So, if a car loan carries a nominal rate of 5 percent and the rate of inflation is 6 percent, the real rate of interest will be -1%.
Effective Interest Rates
Effective interest rates incorporate the concept of compounding interest. It’s the rate you’ll earn or pay on a loan or an investment over a certain period. It’s also known as the annual equivalent rate. The concept of the effective interest rate is crucial in the world of finance, as investors and lenders use it to compare various financial products and calculate compounded interest over different time periods. For instance, if a car loan costs 12 percent, compounded on a monthly basis, while another car loan costs 12.5 percent, compounded on a semi-annual basis, you can use the effective interest rate of both car loans to figure out which one would cost less during the period of one year. A car loan’s effective rate of interest rises with the number of compounding periods. This is why compounding on a quarterly basis will generate higher returns compared to compounding on a semi-annual basis. Similarly, a car loan that compounds monthly will be more expensive than one that compounds quarterly. When a loan with a 10 percent nominal rate of interest is broken down into different periods, the results will be as follows:
- Semi-annually = 10.25 percent
- Quarterly = 10.38 percent
- Monthly = 10.47 percent
- Daily = 10.52 percent
Why Does This Matter
The main benefit of understanding the differences between real, nominal and effective rates is that you’ll be able to make more informed decisions about your investments and loans.