Nominal Interest Rate and Effective Interest Rate

Nominal interest rate and effective interest rate…. you’re paying HOW MUCH?

I’m sorry what? Many of us don’t realize that we are paying more than the posted rates we see in commercials. What we are actually paying is the effective interest rate, which is based on how often the interest on our balance owing is compounded.

The rates we see posted are the nominal interest rates, which are only compounded once a year, but in reality interest can compound, quarterly, monthly or even daily.  Did you know that the interest on most credit cards compounds daily?

As nominal rates are advertised, it is possible to compare rates across banks and products to determine where the cost of borrowing will be the lowest.  For that purpose, nominal interest rates can be useful.

It is important to understand the difference between effective and nominal interest rates so that you can properly evaluate the difference between credit products and really comprehend what you are being charged.

This is why it is possible to have different credit products with the same interest rate and be charged different minimum amounts on a monthly basis.  As a general rule, if you have outstanding debt, it would make financial sense to transfer the debt to the credit product that has both the lowest interest rate and where the interest rate compounds less frequently.

If we realized what we were actually being charged in interest, perhaps we would think twice before we made purchases that we couldn’t actually afford.

Posted on April 13, 2016