Explain when you should use the: nominal rate, periodic rate, effective annual rate, and annual percentage rate.
The correct answer and explanation is:
The nominal rate is used when the interest is stated without considering the effects of compounding during the year. It’s often expressed as an annual rate but may be applied to periods shorter than a year, such as quarterly or monthly. The nominal rate is useful when comparing the basic interest rates without factoring in compounding, making it easier to compare different financial products that use different compounding frequencies.
The periodic rate is the interest rate for a specific compounding period, such as monthly or quarterly. It is typically calculated by dividing the nominal rate by the number of periods in a year. For instance, if the nominal rate is 12% annually, the periodic rate for monthly compounding would be 1% per month (12% ÷ 12 months). This rate is important when you are calculating interest for each period separately, especially in financial transactions like loans or savings accounts that compound interest frequently.
The effective annual rate (EAR) is used to measure the actual interest earned or paid after considering compounding within a year. It reflects the true return on an investment or the real cost of a loan, taking into account the effects of compounding. The EAR is particularly important when comparing different financial products that may have different compounding periods. It provides a more accurate picture of the effective cost or yield by showing how much interest accumulates over the year.
The annual percentage rate (APR) is used mainly in consumer lending, such as credit cards or mortgages, to express the cost of borrowing on an annual basis, including interest and fees. Unlike the nominal rate, the APR incorporates various costs that may be associated with the loan, but it assumes simple interest and does not account for the effects of compounding within the year. APR is useful for understanding the true cost of a loan from the perspective of the borrower, helping to compare different loan offers with varying terms and fees.