Table of Contents
- 1 What is the nominal interest rate?
- 2 Difference between nominal and effective interest rates
- 3 Difference between nominal and real interest rates
- 4 Fixed and flexible interest rate
What is the nominal interest rate?
The nominal interest rate is a kind of money interest. This type of interest is the agreed interest rate, which is due for a loan or which you receive for a financial investment. It does not include any additional costs such as consultancy fees. A period of one year is usually used for the interest rate. The abbreviation "pa" stands for "per year" and derives from the Latin "per anno".
Example: Simple nominal interest calculation
Imagine you borrow from a credit institution an amount of 10.000 Euro at a nominal interest rate of 4%. Therefore, you must pay 400 Euro interest per year. This amount does not cover any additional costs that may arise for you.
Difference between nominal and effective interest rates
The nominal interest rate may differ from the effective interest rate. The interest rate, which is composed of the nominal interest rate and other parts, is designated as the effective interest rate.
Depending on the context in which an interest rate is agreed, the effective interest rate may include different additional costs. The nature of the agreed repayments and interest payments also plays a role.
Credit institutions may charge their processing costs. These processing costs are also included in the effective interest rate. In this case, the effective interest rate rises above the nominal interest rate.
When borrowing money, you should pay attention not only to the nominal interest rate. Please also consider the effective interest rate instead. This must also be specified.
Example: Consider processing fees
Consider the example from the beginning. You borrow 10.000 Euro and agree on a nominal interest rate of 4%. According to this simple calculation, you are paying annually 400 Euro - but the nominal interest rate is covered. Often additional costs are added.
Suppose your bank also charges you a flat rate of 100 Euro processing fees per year. In this calculation example, you no longer pay 400 Euro per year, but effectively 500 Euro. 500 Euro of 10.000 Euro are 5%. If no other direct or indirect costs are added, you will pay an effective annual interest rate of 5%, although the nominal interest rate is still 4%.
Difference between nominal and real interest rates
Real interest also depends on the nominal interest rate. To determine the real interest rate, you must include the inflation rate in your calculation. The real interest rate may refer to past inflation (ex post) or future expected interest rate (ex ante).
The real interest rate can be negative if the inflation rate is above the nominal interest rate.
Example: Quick estimate of the real interest rate
Imagine you have invested your money with a bank and agreed on a nominal interest rate of 5%. If the inflation rate is 2%, the following surplus calculation results:
5 - 2 = 3.
In this example, the real interest rate is approximately 3%. The actual calculation of the real interest rate is much more complex - however, this overhead calculation often gives an approximate idea of how much of the real interest rate will be or will fail.
Fixed and flexible interest rate
The nominal interest rate can either be a fixed number or a flexible variable. A flexible interest rate is tied to a different interest rate, for example, on the capital market rate. In contrast, a fixed (fixed) interest rate is specified with a specific number.
However, a fixed interest rate can also change. However, this change has been agreed upon. For example, it is possible that the interest rate in the first year is 4%, in the second year 4,5% and in the third year 5%. Such an agreement is also laid down in the written contract.