What Is Nominal Interest Rate?

A nominal interest rate does not take into account the fact that the value of money changes and decreases over time due to inflation. This is not necessarily a bad thing, since it is impossible to predict future inflation, and because a fixed rate of return for borrowed funds must be agreed upon beforehand.

In finance and economics nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation (in contrast with the real interest rate); or, for interest rates "as stated" without adjustment for the full effect of compounding (also referred to as the nominal annual rate). An interest rate is called nominal if the frequency of compounding (e.g. a month) is not identical to the basic time unit (normally a year).

A nominal interest rate is one such as the interest rate on a mortgage, or the interest one might earn on a high-yield savings account. It is the interest rate as stated. This is distinct from what is called a real interest rate, which is one that has been adjusted for inflation. Real interest rates are usually lower than nominal interest rates.

For example, if a bank customer puts $1,000 US Dollars (USD) in a certificate of deposit which offers a five percent rate of return, then at the end of a year, there will be $50 USD more in the account, bringing the total to $1,050 USD.

Five percent is the nominal interest rate in the above example. However, if inflation for that year is calculated to be two percent, while this does not affect the nominal interest rate, it does affect the real interest rate.

The customer's dollars may have increased by five percent, but if all money becomes worth two percent less over that time in terms of purchasing power, the real interest rate was actually only three percent. Of course, a three percent real interest rate is better than the two percent decrease in value that the depositor would have experienced otherwise, and this is likely why he put his money on deposit -- to maintain its purchasing power.

Nominal versus effective interest rate

The nominal interest rate is the periodic interest rate times the number of periods per year. For example, a nominal annual interest rate of 12% based on monthly compounding means a 1% interest rate per month (compounded).[2] A nominal interest rate for compounding periods less than a year is always lower than the equivalent rate with annual compounding.

A nominal rate without the compounding frequency is not fully defined: for any interest rate, the effective interest rate cannot be specified without knowing the compounding frequency and the rate. Although some conventions are used where the compounding frequency is understood, consumers in particular may fail to understand the importance of knowing the effective rate.

Nominal interest rates are not comparable unless their compounding periods are the same; effective interest rates correct for this by "converting" nominal rates into annual compound interest. In many cases, depending on local regulations, interest rates as quoted by lenders and in advertisements are based on nominal, not effective interest rates, and hence may understate the interest rate compared to the equivalent effective annual rate.