Effective rate of return refers to the actual interest earned or paid in a year on investments or on borrowings; it includes the effect of compounding in its calculation while the nominal interest rate refers to the interest rate which is calculated without taking the effect of compounding into consideration. Both of these returns are complimentary to each other, therefore it is important to understand the meaning & concept of both for a better clarification.
Nominal interest rate is usually quoted for the contractual rates for example; an interest rate quoted by the bank is often called as a Nominal interest rate and when we calculate the Effective rate of return for the same, it is coming out to be more than the nominal interest rate because of the compounding factor.
A nominal interest rate of 18% based on monthly compounding means a 1.5%(18%/12) interest rate per month i.e. the bank will give you 1.5% interest each month on your deposits which means the actual interest which you will earning at the end of one year comes out to be 19.56%.
Thus, a nominal rate of 18% per annum compounded monthly is equal to annual effective rate of 19.56%.
Effective rate of return is calculated as:
r = nominal interest rate per year
n = number of interest period per year
To make it simpler, we have calculated below the effective rate of interest for different interest period per year:
Nominal Rate Vs Effective Rate
|Nominal Rate of 10% if compounding||Annual Effective Rate|
Thus, it is seen that higher the period of compounding for a nominal interest rate, higher the effective rate of interest over a definite time span. So from an analysis point of view, you can only compare two nominal rates of different investment options when their compounding periods are same.