Finance 331-Chapter 5

Comparing Interest Rates

Different compounding periods are used for different types of investments. In order to properly compare investments or loans with different compounding periods we need to put them on a common basis. In order to do this you need to understand the difference between the nominal interest rate (INOM) and the effective annual rate (EAR).

Nominal Interest Rate

is quoted by borrowers and lenders and it is also called the annual percentage rate (APR). If compounding periods for different securities is the same then you can use the APR for comparison. If the securities have different compounding periods then the EAR must be used for comparison.

M is the number

of compounding periods per year and INOM/M is equal to the periodic rate (IPER). If a loan or investment uses annual compounding then the nominal interest rate is also its effective annual rate. However if compounding occurs more than once a year EAR is higher than INOM.