The nominal interest communicated by a nominal interest rate is a basic interest calculation which does not account for other factors like inflation, costs or the way in which interest is applied. Typically, nominal interest is shown as an annual interest rate.
The terms nominal interest and nominal interest rate are often used synonymously. However, a nominal interest rate is shown as a percentage (1%, for example) while nominal interest is shown as an amount (40 francs, for example).
The actual amount of interest owed may differ between loans which have the same nominal interest rate, depending on how their interest is calculated. The day-count convention used is one example of a variable which may affect the effective annual interest rate. This is especially true when interest is paid at intervals shorter than one year. Interest compounding intervals shorter than one year are not accounted for by nominal interest either. The actual effective interest of loans which compound interest more than once per year is higher than that of loans which compound annually, even when the nominal interest rate is identical.
Nominal interest rates are used in relation to Swiss savings accounts, private accounts, 3a retirement accounts, medium term notes and mortgages. Unlike real interest, nominal interest does not account for inflation.
When intra-year interest compounding intervals and loan costs are accounted for in an interest rate, the result is an effective interest rate. Effective annual interest rates play an important role in determining the cost of loans. They communicate the total cost of a loan. In Switzerland, effective annual interest rates are used for personal loans and credit card loans.
Intra-year interest payments: Example
Nominal interest rates can also serve as a basis for calculating interest when interest is paid out at multiple intervals within each year of the loan term.
Example: A loan of 1000 francs with a loan term of 1 year has a nominal interest rate of 10% per year. The loan repayment and the interest payment are both due at the end of the one-year term (one year interest compounding interval). In this case, the borrower must pay 1100 francs at the end of the loan term (100 francs of interest plus the 1000 franc loan repayment). The effective annual interest rate in this case matches the nominal interest rate.
If interest on the same loan were compounded twelve time per year at the end of each month, with the loan being repaid with interest at the end of the one-year term, the interest would come to around 104.71 francs. You can confirm this example using the effective vs. nominal interest rate calculator.
The difference of 4.71 francs is the result of interest being charged on the interest paid out each month (the compounding interest effect):
Interest in month 1 = 10% /12 * 1000 francs ≈ 8.33 francs
Interest in month 2 = 10% / 12 * (1000 + 10% / 12 * 1000) francs ≈ 8.40 francs
Interest in month 3 ≈ 8.47 francs
And so on.
The true interest rate can be calculated using this formula: Total interest = (1 + 10% / 12)^12 * 1000 francs – 1000 francs = 104.71 francs. In this case the effective annual interest rate – and therefore the true cost of the loan – is around 10.47%, although the nominal interest rate is lower at 10%.