While doing some research on the internet, I encountered a peculiar statement, "An investment's nominal interest rate will always be equal to or greater than its effective annual (rate)." To the initiated, this statement is neither reliable nor correct. The link between an investment's nominal and effective rate is only meaningful if given for a certain compounding period.

The definition of "nominal rate" in this context is the rate per compounding period. Technically, the compounding period can be for any period (more than a year, one year or less than a year). The effective rate for an investment is the rate that financial institutions quote for a compounding period equal to a year. Therefore, you can correctly refer to the effective rate as the annualized rate.

Financial institutions typically quote interest rates effectively, regardless of the compounding periods that they use to apply interest. This is because the year is a basic unit of time in the realm and finance. It may also be because it allows for better comparisons and, from a marketing perspective, the effective rate normally appears greater than the nominal rate.

Although the compounding period for an investment could exceed a year, this is very rarely the case. Compounding periods are usually daily, weekly, monthly, quarterly, semi-annual or annual. For an investment, the nominal rate is likely to either be equal to or lower than the effective (or annualized) rate. This is because compounding periods for investments are typically less than one year. The nominal rate is equal to the effective rate when the compounding period is equal to one year.

For example, assume that the effective interest rate for an investment is equal to 6%. The nominal rates for the compounding periods less than one year will necessarily be lower than 6% as the figures below indicate:

Compounding Period Nominal interest rate
Daily 5.8274%
Weekly 5.8302%
Monthly 5.8411%
Quarterly 5.8695%
Semi-annually 5.9126%

One can safely suggest that the more frequent the period of compounding is, the lower the nominal interest rate is going to be in relation to the effective interest rate. If the compounding period were greater than one year, that is the only time that the nominal interest rate could exceed the effective interest rate.

This suggests that when you are calculating the dollar value of interest or rates of return on an investment- where the compounding period is more frequent than a year- the rate that you should correctly use is the nominal rate. The correct statement to make on the link between nominal and effective rates for an investment is that, "Where compounding occurs more than once a year, the nominal interest rate would be lower than the effective interest rate."

Learn more about this author, Darrell Victor.
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