A nominal interest rate is the proportion of your investment that a bank will pay you. It is expressed as an annual percentage. The effective interest rate, however, is an expression of how much those earnings are actually worth.
Inflation
Inflation is when goods rise in price or money lowers in value. Either way, in an inflation year, money buys less at the end than it did at the beginning.
Nominal Interest Rate
As stated above, the nominal interest rate is what the bank publishes as its interest rate, either on loans or bank accounts.
Effective Interest Rate
The effective interest rate is what the money is actually worth. It is the interest rate minus the inflation rate.
An Example
Assume you invest $1,000 in an account paying 4 percent interest in a year that the inflation rate is 2 percent. You will still receive $1,040 at the end of the year, but it will only buy as much as $1,020 did at the beginning of the year.
Advantages
While this is a drawback of putting money in a bank, it is an advantage of borrowing money from it--if you borrow $100,000 at a 5 percent nominal interest rate and inflation immediately spikes to 6 percent, then you have actually earned 1 percent in value.
Value, Not Amount
It is very important to clarify that the effective interest rate refers to the interest rate's value, not its amount. The amount is only effected by the nominal interest rate.
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