What Does nominal rate Mean
A rate is a coefficient that reflects the relationship between two magnitudes and allows different concepts to be expressed, such as interest (the utility, value or profit of something). The interest rate , in this sense, is an index that is expressed as a percentage and is used to estimate the cost of a loan or the profitability of savings.
It is known as nominal interest rate or rate nominal to the interest capitalizes on more than once a year . It is a reference value used in financial operations that is usually set by the authorities to regulate loans and deposits.
The nominal rate is equal to the interest rate per period multiplied by the number of periods . The effective rate, on the other hand, is the real interest that a person pays on a credit or charges on a deposit.
Although it is framed in a certain period of time, the nominal rate contemplates various interest payments in that period. With the effective rate, the yield is calculated in a single payment per period.
For example: the nominal rate is usually expressed on an annual basis . The contracts, however, can specify that the interest will be calculated several times during the year (either monthly, quarterly or semi-annually, among others). The year, therefore, can be divided into twelve months, four quarters, or two semesters. If the interest rate is 2% per quarter, it is possible to speak of a nominal annual rate of 8% (since the year has four quarters).
A concept closely linked to the nominal rate is that of profitability ; It is about the profit margin that an investment can return. If the time it takes to obtain these benefits is taken into account, then the expression "gain over time" is used. Let's look at an example: if a house is purchased for $ 500,000 and after a year it is sold for $ 510,000, the profit that will have been obtained in 12 months is $ 10,000. Put in other words, if instead of buying the property the $ 500,000 is invested knowing that for every $ 100 $ 2 will be received, at the end of the same period the $ 10,000 could be obtained.
This money is used by the recipient to produce more, so that he can pay the profit to the investor ($ 2 per $ 100) and, the longer it is given, the more profit he will be able to generate. Returning to the nominal interest rate, it can be said that it is the profitability obtained from a financial product month by month or in a particular period of time, simply taking into account the capital of the initial investment and it is considered a type of simple capitalization.
Given the previous example, it is easy to understand its main difference with the effective interest rate: both the initial capital and the interest that are produced in each period are taken into account. It is a type of compound capitalization, since the interest generated periodically is added to the capital and based on this amount, the interest for the following period is settled.
Both types of interest rate coincide if it is established that the interest generated is paid only at the end of the life of the financial product; On the other hand, if more than one payment is made, the nominal one is inevitably lower than the effective one.
If a term certificate of deposit (CDT) is contracted for 6 months for the value of $ 5000 with a nominal annual rate of 5%, when the period ends we will obtain only 2.5% of the capital. On the other hand, the same deposit with an effective annual rate (also 5%) will return 2.47%, since in the latter case the interest is charged month by month.