What is the nominal interest rate?

When it comes to personal finance, it’s important to know how your savings accrue interest. When you deposit money into a savings account, you earn interest, but not all interest rates are created equal. You might have seen the term nominal interest rate used in connection with financial products and wonder what it means. 

On this page, we explain the meaning of nominal interest rate and how nominal rates differ from effective and real interest.

The nominal interest rate is the interest rate stated on a loan or investment before inflation is taken into account. In some cases, nominal rates don’t consider fees or the compounding of interest.

You might have seen the nominal interest rate in promotional materials for savings accounts or credit cards. For example, a savings account might be advertised with a “1.5% annual interest rate”, which is the nominal rate.

The nominal rate is easy to calculate and reflects the amount of interest earned or paid in absolute terms, making it useful for providing a basic comparison of financial options.

In the UK, the Bank of England (BoE) plays a major role in setting the nominal interest rate. You might have seen the nominal rate referred to as the ‘Bank of England base rate’ or just ‘the interest rate’ in the news. This rate is important as it serves as the basis for other interest rates charged by banks and financial institutions.

The Monetary Policy Committee (MPC) is a key group within the BoE when it comes to setting these rates. This committee keeps an eye on the economy and aims to keep inflation low and stable. To do this, they adjust the Bank Rate, which influences how much it costs to borrow money, as well as the overall economic growth and inflation levels.

The MPC might decide to keep interest rates low during difficult economic periods, like during a recession. This encourages people to borrow money and spend it, which can help the economy recover. When prices start rising quickly, the BoE might then increase interest rates to keep inflation under control.

Nominal interest rates are widely used in finance and economics. Banks use nominal rates to calculate loan interest, savers use them to work out how much money they’ll earn on their savings accounts, and those investing in bonds receive interest payments based on nominal interest rates. 

Understanding nominal rates is helpful for borrowers, lenders, investors, or anyone involved in monetary policy decisions.

In most cases, when people refer to the nominal interest rate without specifying the period, they usually mean the annual nominal interest rate.

Here are some examples of what this might look like:

Savings accounts:

A bank advertises a savings account with a nominal annual interest rate of 3%. This means that if you deposit £1,000 into this account, you would expect to earn £30 in interest over the course of one year.

Loans:

The nominal interest rate can also be used by consumers to calculate and compare interest on loans. A consumer takes out a personal loan with a nominal interest rate of 6%. For a £5,000 loan, the borrower would owe £300 in interest charges per year, assuming the loan is not compounded.

Credit cards:

A credit card company offers a card with a nominal interest rate of 18% APR (Annual Percentage Rate). If you have a balance of £1,000 on this card for a year, you would owe £180 in interest charges.

The nominal interest rate provides a basic measure of the annual interest rate on financial products. In reality, however, you’re likely to find fees and compounding on savings accounts and credit cards, and the actual interest charges or earnings can vary depending on how frequently interest is compounded.

The nominal interest rate shows the actual cost for borrowers and the earnings for lenders without considering inflation. On the other hand, the real interest rate accounts for the effects of inflation, giving a clearer idea of how much your money will be worth in the future. It’s calculated by subtracting the inflation rate from the nominal interest rate.

While nominal rates are easy to understand and often higher, real rates generally give a more accurate view of value. Investors and lenders usually prefer the real interest rate because it provides a better understanding of the actual purchasing power of their money over time.

There’s a third form of interest rate called the effective interest rate. This is also known as the Annual Equivalent Rate (AER). Unlike the nominal rate, the effective rate accounts for the compounding period. This is the rate you’ll typically find on savings accounts in the UK, as it makes it easy to compare accounts with different compounding terms.

With compound interest, any interest earned in the following year is calculated not only on your original deposit, but also on the interest you earned during the previous year. Compounding periods can also be monthly or quarterly. Compounding is like a snowball effect, boosting the growth of your savings over time.

So, while the nominal rate shows you the interest earned annually, the effective rate indicates the interest earned when it’s added to the account balance monthly, quarterly, or otherwise. The effective rate can therefore give you a clearer understanding of the amount of interest you will actually earn on your savings.

To calculate the effective interest rate, you typically start with the nominal interest rate given by your bank or lender. If you don’t have that, you can use the nominal interest rate formula. Simply divide the interest earned or paid by the initial deposit or investment, then multiply by 100 to get the result as a percentage.

Next, you can use the following formula:

Effective interest rate = (1 + (n / m))^m - 1

where

n = nominal interest rate (as a decimal)

m = number of compounding periods per year

Example:

If you have a savings account with a nominal annual interest rate of 5% and interest is compounded monthly, the effective interest rate would be calculated as:

n = 0.05 (5% nominal rate)

m = 12 (compounded monthly)

Effective interest rate = (1 + (0.05 / 12))^12 - 1 = 0.0512 or 5.12%

So, if you deposit £1,000 in this savings account, you’d earn approximately £51.20 in interest over one year.

On the Raisin UK marketplace, you can easily compare savings accounts using AER.

Understanding the difference between nominal, real and effective interest rates can be helpful to savers because each option affects purchasing power differently.

For savers, real interest rates can be more informative because they reveal how much their savings are actually growing. For instance, if the nominal interest rate on a savings account is 5%, but inflation is 3%, the real interest rate is only 2%. This means that while your savings are increasing, their purchasing power is only growing at a rate of 2%.

Effective interest rates that account for compounding are particularly important because they can provide a more accurate picture of how much your savings or investments will actually grow over time.

In the table below you can find a brief overview of the differences between nominal, effective and real interest for an initial deposit amount of £10,000, and an inflation rate of 2.3% per year:

When comparing savings accounts, it can help to look beyond the nominal interest rate. You can find out what you’ll actually earn by looking at the effective savings interest rate. Raisin UK makes this easy; just compare savings accounts in the table by AER, and explore each account’s terms. Once you’ve chosen, you can get started by registering for a free Raisin UK Account.