Nominal Rate, Real Rate, and EAR: Don't Let the Numbers Fool You
Is “12% per year” the same as “1% per month”? Not once compounding enters the picture — and the gap can be costly.
Loan ads love “0.5% per month.” Deposit products love “4% annualized.” Both look reasonable, but if you don't understand how interest is compounded, you'll underestimate true cost and overestimate true return.
Three terms you must separate
- Nominal rate: the stated annual rate in the contract, ignoring compounding frequency.
- Periodic rate: the rate per compounding period — monthly rate = nominal annual rate ÷ 12.
- Effective annual rate (EAR/APY): the true annual cost or return once compounding is included.
How compounding frequency changes things
A 12% nominal rate compounded annually gives an EAR of 12%. Compounded monthly, the periodic rate is 1% and the true annual cost is (1 + 1%) ^ 12 − 1 ≈ 12.68%. Daily compounding pushes it higher still.
The gap looks small, but on a large balance over decades it is real money. Always convert products to a common basis before comparing.
Practical steps
When you get a quote, ask three things: what is the nominal annual rate, how often does it compound, and are there fees? Many “low-rate” products hide their true cost in fees. Enter different parameters in the Loan Calculator to compare monthly payments and total cost.
For savings, use the Compound Interest Calculator to estimate actual returns at different compounding frequencies, so marketing language doesn't mislead you.