Nominal Interest Rate. MarketCheese

Nominal interest rate means the market interest rate, expressed in numerical terms, without reference to inflation. It reflects the current valuation of monetary assets.

The term shows the increase in the nominal value of cash:

on bank deposits;
issued by the financial institutions as a loan.

Essence of Nominal Interest Rate

Usually, national banks establish short-term nominal interest rates that set the stage for other rates of interest collected by monetary institutions. After a sharp economic slowdown these nominal interest rates can be kept artificially down in order to boost the business operations via low real ones. The presented measures send a strong signal for the consumers to incur debts and lay out financial facilities.

Nevertheless, a prerequisite for such stimulus moves is inflation that doesn’t constitute a real threat to the economy, especially in the short run. In contrast, central banks of different countries have a tendency to establish high nominal interest rates. These financial institutions can overestimate the inflation level, maintaining rates unreasonably high. As a consequence, strong economic headwinds are expected.

In fact, there are several types of interest rates, including:

Real interest rate, demonstrating a real wealth growth. As a rule, this indicator is of great significance for the investors and loan holders. It expresses the increase in the purchasing power of the sides. The rate takes into account all borrower’s expenses in favor of the lender (usually bank) associated with the execution, receipt and servicing of the loan.
Effective interest rate, rendering the real value of the loan. So, in addition to the borrowing costs, it also takes into account all associated expenditures (commissions) for servicing. In other words, this is the nominal rate plus the capitalization, which is obtained by accruing interest on a deposited amount, and also by the bank institutions.

As a rule, a consumer renders payments due to the effective interest rate, not a nominal one. It varies from charges and compounding effects.

Constituencies of Nominal Interest Rate

The bank may promise super favorable conditions, but, as a result, a person has to overpay 2-3 times more than expected. This situation often happens as individuals don’t pay attention to the constituencies of a nominal interest rate.

Let’s consider what parts are included in the term:

only the direct interest on the loan or deposit.

Other constituencies that are not incorporated into a nominal interest rate, are:

additional commissions (for reducing the overpayment, for a fixed overpayment, etc.);
service charges;
SMS and other forms of informing;
online banking, or provided card payment (if these services are offered);
insurance payment;
inflation.

Calculating the Nominal Interest Rate

A higher nominal interest rate guarantees a higher profitability of a financial transaction, only if the accrual periods are equal. In practice, this condition is often met. So, in the banking sector, almost all credit operations involve monthly interest.

Therefore, the nominal interest rate is the indicator, at which the nominal value of cash increases over time. The rate for a particular period is calculated according to the Fischer formula, referred to below.

where the metrics signify:

Ir - a nominal interest rate;
In - a real interest rate;
π - an expected or projected inflation rate.

Pros of the concept

Using a nominal interest rate contemplates particular advantages:

It is easier to determine the interest for the accrual period. So, with a semi-annual accrual, the nominal rate can be divided by two, while with a monthly accrual - by twelve.
The indicator is simple in understanding for a person inexperienced in financial calculations.
The rate contemplates an automatic elimination of the fluctuation effect in a real income on the monetary market.