Nominal and Effective

Interest Rates
Chapter 3
Understanding Money Management

Nominal and Effective

Interest Rates
Equivalence Calculations
using Effective Interest
Rates

Debt Management
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?
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
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
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%
18%

= 1.5%
Effective Annual Interest Rate (Yield)

ia (1 r / M ) 1 M

r = nominal interest rate per year

ia = effective annual interest rate
M = number of interest periods per
year
 18%

: 1.5%
18% compounded monthly
or
1.5% per month for 12 months
=

19.56 % compounded annually

Practice Problem

Suppose your savings account pays 9%

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

Market Interest Rates (Nominal versus Effective Interest Rates)
3.1 A loan company offers money at 1.5% per month compounded monthly.
(a) What is the nominal interest rate?
(b) What is the effective annual interest rate?
3.2 A department store has offered you a credit card that charges interest
at 1.75% per month compounded monthly. What is the nominal interest
(annual percentage) rate for this credit card? What is the effective annual
interest rate?
3.3 A discount interest loan is a loan arrangement where the interest and
any other related charges are calculated at the time the loan is closed.
Suppose a one-year loan is stated as $10,000 and the interest rate is
14%. Then, the borrower pays $1,400 interest up front, thereby receiving
net funds of $8,600 and repaying $10,000 in a year. What is the effective
interest rate on this one-year loan?
3.4 A California bank, Berkeley Savings and Loan, advertised the following
information: 7% interest and effective annual yield 7.22%. No mention is
made of the interest period in the advertisement. Can you figure out the
compounding scheme used by the bank?
3.5 American Eagle Financial Sources, which makes small loans to college
students,offers to lend a student $600. The borrower is required to pay $4
at the end of each week for 13 weeks. Find the interest rate per week.
What is the nominal interest rate per year? What is the effective interest
Why Do We Need an Effective Interest
Rate per Payment Period?
Payment period

Interest period

Payment period

Interest period

Payment period

Interest period
Effective Interest Rate per Payment Period
(i)( Discrete Compounding)
If cash flow transactions occur quarterly, but interest is
compounded monthly, we may wish to calculate the effective
interest rate on a quarterly basis. To consider this situation, we
may redefine as:

i [1 r / CK ] 1 C

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
12% compounded monthly
Payment Period = Quarter
Compounding Period = Month

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

One-year

K= 4
C=3
M=12 C

I = [1 + r/CK] -1
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
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
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
Effective Interest Rate per Payment Period with
Continuous Compounding

i [1 r / CK ] 1 C

where CK = number of compounding periods

per year

continuous compounding => C

i lim[(1 r / CK ) 1]
C

(e )
r 1/ K
1
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
Summary: Effective interest rate per quarter

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
 Case I: When Payment Periods and
Compounding periods coincide (M=K)
Step 1: Identify the number of compounding
periods (M) per year
Step 2: Compute the effective interest rate per
payment period (i)
i = r/M
Step 3: Determine the total number of payment
periods (N)
N = M X (number of years)
Step 4: Use the appropriate interest formula
using i and N
Example 3.4: Calculating Auto Loan Payments

Given:
Invoice Price = $21,599
Sales tax at 4% = $21,599 (0.04) = $863.96
Dealers freight = $21,599 (0.01) = $215.99
Total purchase price = $22,678.95
Down payment = $2,678.95
Dealers interest rate = 8.5% APR
Length of financing = 48 months
Find: the monthly payment
Solution: Payment Period = Interest Period

$20,000
1 2 3 4 48
0
A
Given: P = $20,000, r = 8.5% per year
K = 12 payments per year
Find A

tep 1: M = 12
S
Step 2: i = r/M = 8.5%/12 = 0.7083% per month

Step 3: N = (12)(4) = 48 months

Step 4: A = $20,000(A/P, 0.7083%,48) = $492.97

Calculating an Effective Interest Rate Based on a Payment
Period
3.12 Find the effective interest rate per payment period for an interest rate of 8%
compounded monthly for each of the given payment schedule:
(a) Monthly
(b) Quarterly
(c) Semiannually
(d) Annually
3.13 What is the effective interest rate per quarter if the interest rate is 10%
compounded monthly?
3.14 What is the effective interest rate per month if the interest rate is 9%
compounded continuously?
3.15 What is the effective interest rate per quarter if the interest rate is 8%
compounded continuously?
3.16 James Hogan is purchasing a $30,000 automobile, which is to be paid for in 48
monthly installments of $650. What is the effective interest rate per month for
this financing arrangement?
3.17 Find the APY in each of the following cases:
(a) 10% compounded annually.
(b) 9% compounded semiannually.
(c) 12% compounded quarterly.
(d) 7% compounded daily.
 Practice Problems
3.19 What is the future worth of each of the given series of payments?
(a) $12,000 at the end of each six-month period for 12 years at 8% compounded
semiannually.
(b) $8,000 at the end of each quarter for 6 years at 12% compounded quarterly.
(c) $6,000 at the end of each month for 5 years at 6% compounded monthly.

3.20 What equal series of payments must be paid into a sinking fund in order to
accumulate each given amount?
(a) $1,700 in 10 years at 8% compounded semiannually when payments are
semiannual.
(b) $9,000 in 6 years at 3% compounded quarterly when payments arc quarterly.
(c) $4,000 in 2 years at 12% compounded monthly when payments are monthly.

3.21 What is the present worth of each of the given series of payments?
(a) $2.700 at the end of each six-month period for 10 years at 8% compounded
semiannually.
(b) $10,000 at the end of each quarter for five years at 12% compounded quarterly.
(c) $14.000 at the end of each month for eight years at 6% compounded monthly.
3.25 Suppose a newlywed couple is planning lo buy a home two years from now. To save
the down payment required al the time of purchasing a home worth $400,000 (let's
assume this required down payment is 25% of the sales price, or $100,000), the couple
has decided to set aside some money from their salaries at the end of each month. If the
couple can earn 9% interest (compounded monthly) on their savings. determine the equal
amount the couple must deposit each month so that they may buy the home at the end of
two years.

3.27 A man is planning to retire in 25 years. He wishes to deposit a regular amount

every three months until he retires so that, beginning one year following his retirement,
he will receive annual payments of $50,000 for the next 10 years. How much must he
deposit if the interest rate is 9% compounded quarterly?

3.33 Sam Musso is planning to retire in 20 years. He can deposit money at 12%
compounded quarterly. What deposit must he make at the end of each quarter until he
retires so that he can make a withdrawal of $55,000 semiannually over five years after
his retirement? Assume that his first withdrawal occurs at the end of six months after
his retirement.

3.38 Maria Anguiano's current salary is $80,000 per year, and she is planning to retire 25
years from now. She anticipates that her annual salary will increase by 3% each year.
(That is, in the first year she will earn $82,400, in the second year $84,872, in the third
year $87,418.16, and so forth.) She plans to deposit 6% of her yearly salary into a
retirement fund that earns 8% interest compounded monthly. What will be the amount
accumulated at the time of her retirement?
3.45 What is the required quarterly payment to repay a loan of $30,000 in six
years? If the interest rate is 9% compounded continuously?
3.46 A series of equal quarterly payments of $2,500 extends over a period of
four years. What is the present worth of this quarterly-payment series at 8%
interest compounded continuously?
3.47 A series of equal quarterly payments of $5,000 for 10 years is equivalent
to what future lump-sum amount at the end of 15 years at an interest rate of
6% compounded continuously?

3.56 Taibi Hafid is considering the purchase of a used car. The price, including the
title and taxes, is $10,500. Taibi is able to make a $2,500 down payment. The
balance, $8,000, will be borrowed from his credit union at an interest rate of 10%
compounded daily. The loan should be paid in 48 equal monthly payments.
Compute the monthly payment. What is the total amount of interest Taibi has to pay
over the life of the loan?
3.57 Janie Curtis borrowed $25,000 from a bank at an interest rate of 12%
compounded monthly. This loan is to be repaid in 48 equal monthly installments
over four years. Immediately after her 20th payment, Janie desires to pay the
remainder of the loan in a single payment. Compute the total amounts she must
pay at that time.
3.54 You borrow $200,000 with a 25-year payback term and a variable APR that
starts at 8% and can be changed every five years. (a) What is the initial monthly
payment? (b) If, at the end of five years, the lender's interest rate changes to 9%
(APR), what will the new monthly payment be?
3.59 For a $425,000 home mortgage loan with a 20-year term at 8% APR
compounded monthly, compute the total payments on principal and interest over
the first five years of ownership.

3.60 A lender requires that monthly mortgage payments be no more than one
third of gross monthly income, with a maximum term of 20 years. If you can
make only a 20% down payment, what is the minimum monthly income you
would need in order to purchase a $420,000 house when the interest rate is 12%
compounded monthly?

3.61 To buy an $180,000 condominium, you put down $30,000 and take out a
mortgage for $150,000 at an APR of 9% compounded monthly. Five years later,
you sell the house for $205,000 (after all selling expenses are factored in). What
equity (the amount that you can keep before any taxes are taken out) would you
realize with a 30-year mortgage repayment term? (Assume that the loan is
paid off when the condo is sold in lump sum.)
Practice Problem

You have a habit of drinking a cup of Starbuck

coffee ($2.00 a cup) on the way to work every
morning for 30 years. If you put the money in the
bank for the same period, how much would you
have, assuming your accounts earns 5% interest
compounded daily.

NOTE: Assume you drink a cup of coffee every day

including weekends.
Solution

Payment period: Daily

Compounding period:
Daily

5%
i 0.0137% per day
365
N 30 365 10, 950 days
F $2( F / A, 0.0137%,10950)
$50, 831
Case II: When Payment Periods Differ from Compounding
Periods M K
Step 1: Identify the following parameters
M = No. of compounding periods
K = No. of payment periods
C = No. of interest periods per payment period
Step 2: Compute the effective interest rate per payment
period
For discrete compounding
i [1 r / CK ] 1
C

For continuous compounding

i er / K 1
Step 3: Find the total no. of payment periods
N = K X (no. of years)
Step 4: Use i and N in the appropriate equivalence formula
Example Discrete Case: Quarterly deposits with Monthly
compounding ( Nominal interest rate = 12%)

Year 1 Year 2 Year 3

F=?
0 1 2 3 4 5 6 7 8 9 10 11 12
Quarters
A = $1,000
Step 1: M = 12 compounding periods/year
K = 4 payment periods/year
C = 3 interest periods per quarter
Step 2: i [1 0.12 /(3)( 4)]3 1
3.030%
Step 3: N = 4(3) = 12
Step 4: F = $1,000 (F/A, 3.030%, 12)
= $14,216.24
Continuous Case: Quarterly deposits with Continuous
compounding
(Nominal interest rate = 12%)

Year 1 Year 2 Year 3

F=?
0 1 2 3 4 5 6 7 8 9 10 11 12
Quarters
A = $1,000
Step 1: K = 4 payment periods/year
C = interest periods per quarter
Step 2:

ie0 .12 / 4
1
3.045% per quarter
Step 3: N = 4(3) = 12
Step 4: F = $1,000 (F/A, 3.045%, 12)
= $14,228.37
Practice Problem

A series of equal quarterly payments of

$5,000 for 10 years is equivalent to what
present amount at an interest rate of 9%
compounded
(a) quarterly
(b) monthly
(c) continuously
Solution

A = $5,000

1 2 40 Quarters
 (a) Quarterly

Payment period :
A = $5,000
Quarterly
Interest Period:
0
Quarterly
1 2 40 Quarters

9%
i 2.25% per quarter
4
N 40 quarters
P $5, 000( P / A, 2.25%, 40)
$130,968
 (b) Monthly
Payment period :
A = $5,000
Quarterly
Interest Period: Monthly
0

1 2 40 Quarters
9%
i 0.75% per month
12
i p (1 0.0075)3 2.267% per quarter
N 40 quarters
P $5, 000( P / A, 2.267%, 40)
$130,586
 (c) Continuously
Payment period :
A = $5,000
Quarterly
Interest Period:
0
Continuously
1 2 40 Quarters

i e0.09 / 4 1 2.276% per quarter

N 40 quarters
P $5, 000( P / A, 2.276%, 40)
$130,384
Debt Management
Methods of Calculating Interests on your Credit
Card
Method Description
Adjusted Balance The bank subtracts the amount of
your payment from the beginning
balance and charges you interest
on the remainder. This method
costs you the least.
Average Daily Balance The bank charges you interest on
the average of the amount you
owe each day during the period.
So the larger the payment you
make, the lower the interest you
pay.
Previous Balance The bank does not subtract any
payments you make from your
previous balance. You pay
interest on the total amount you
owe at the beginning of the
period. This method costs you the
most.
Interest You Owe
Your beginning balance is $3,000.
With the $1,000 payment, your
new balance will be $2,000. You
pay 1.5% on this new balance,
which will be $30.
Your beginning balance is $3,000.
With your $1,000 payment at the
15th day, your balance will be
reduced to $2,000. Therefore,
your average balance will be
(1.5%)($3,000+$2,000)/2=$37.50.
Regardless of your payment size,
the bank will charge 1.5% on your
beginning balance $3,000:
(1.5%)($3,000)=$45.
41
ApplicationsLoan Analysis

$20,000

1 2 24 25 48
0

Given: APR = 8.5%, N = 48 months, and

P = $20,000
Find: A
A = $20,000(A/P,8.5%/12,48)
= $492.97
Suppose you want to pay off the remaining loan in lump sum
right after making the 25th payment. How much would this
lump be?
$20,000

1 2 24 25 48
0
$492.97 $492.97
25 payments that were 23 payments that are
already made still outstanding

P = $492.97 (P/A, 0.7083%, 23)

= $10,428.96
 Accounting Data - Buying vs. Lease
Cash Outlay for Buying : $25,886

Down payment: $2,100

Car Loan at 8.5%
(48 payments of $466): $22,368
Sales tax (at 6.75%): $1,418

Cash Outlay for Leasing : $15,771

Lease (48 payments of $299) : $14,352

Sales tax (at 6.75%): $969
Document fee: $450
Refundable security deposit (not included
in total) : $300
Example 3.9 Buying versus Lease Decision
Option 1 Option 2
Debt Financing Lease
Financing
Price $14,695 $14,695
Down payment $2,000 0
APR (%) 3.6%
Monthly payment $372.55 $236.45
Length 36 months 36 months
Fees $495
Cash due at lease end $300
Purchase option at lease $8.673.10
end
Cash due at signing $2,000 $731.45
Which Interest Rate to Use to
Compare These Options?
Your Earning Interest Rate = 6%

Debt Financing:
Pdebt = $2,000 + $372.55(P/A, 0.5%, 36)
- $8,673.10(P/F, 0.5%, 36)
= $6,998.47
Lease Financing:
Please =$731.45) + $236.45(P/A, 0.5%, 35)
+ $300(P/F, 0.5%, 36)
= $8,556.90
Summary

Financial institutions often quote interest rate

based on an APR.
In all financial analysis, we need to convert
the APR into an appropriate effective interest
rate based on a payment period.
When payment period and interest period
differ, calculate an effective interest rate that
covers the payment period. Then use the
appropriate interest formulas to determine the
equivalent values