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Interest Rates - Nominal, Effective, Compound

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Glossary -> Interest Rates

Interest Rates - Nominal, Effective, Compound

The nominal rate is the annual interest rate before adjusting for the effect of compounding.  When an interest rate is stated with its compounding frequency (e.g. 6% compounded monthly), the stated rate is the nominal rate.

The effective rate is the annual interest rate after adjusting for the effect of compounding.

Compound interest is interest on interest.  The more frequent the compounding, the higher the interest.

Interest earned or paid for 1 year on $10,000 at a 6% nominal rate

Compounding Interest Effective rate
daily
365 times per year
$618.31 6.183%
monthly
12 times per year
$616.78 6.168%
semi-annual
2 times per year
$609.00 6.090%
annual
once per year
$600.00 6.000%

Interest earned on chequing and savings accounts is usually calculated on the balance in the account at the end of each day, but is paid monthly, therefore it is compounded monthly.  Once the interested is added to the account, the next month's interest is calculated on the balance which includes the prior month interest.

Interest earned on term deposits and guaranteed investment certificates (GICs) are compounded at various frequencies.  When you are investing in these products, make sure you compare the effective rates of different options, not the nominal rate.

Mortgage interest is usually compounded semi-annually or monthly.  Payments on the mortgage can usually be paid monthly, bi-weekly, or weekly, but this does not affect the frequency of compounding.

Interest charged by Canada Revenue Agency (CRA) on overdue amounts is compounded daily.

When the term fixed rate is used in reference to a loan, it means that the rate will not change during the term of the loan.  The interest rate on a variable rate loan will fluctuate every time there is a change in the bank's prime rate.

To see how a different interest rate or higher payments would affect your loan or mortgage, see our Loan and Mortgage Calculator.

Tax Tip:  Always compare effective interest rates to make sure you get the best rate!

Revised: February 08, 2017

 

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