- Compound interest refers to a form of interest calculation in which previously accrued interest has interest applied to it. For example, if a borrower takes out a $100 loan at six percent interest compounded annually, the interest accrued will be $6 at the end of the first year and $112.36 after the second year. The additional $0.36 comes from the fact that the interest from the previous term accrues its own interest.
- A nominal interest rate is a rate stated in the contractual agreement. For example, if an agreement states, "Interest on this loan will be compounded annually at a rate of six percent per year for a ten year period," the nominal interest rate is six percent, because it is the rate specifically stated in the agreement.
- The effective interest rate is the rate of interest that is actually paid by the borrower. In the example given above, the nominal interest rate is six percent. However, because interest is compounded each year over a 10-year period, the effective, or actual, interest rate on the loan over this 10-year period will be higher than six percent.
- To calculate the effective interest rate from a nominal interest rate, use the following formula: r = (1 + i/n) ^ n, where "r" is the effective interest rate, "i" is the nominal interest rate and "n" is the number of compounding periods. So, using the previous example, if an agreement states that six percent interest will be compounded annually for ten years on a $100 loan, the effective interest rate is equal to (1 + .06/10) ^ 10 = 6.165 percent.
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