WHAT IS A NOMINAL AND EFFECTIVE INTEREST RATE? | Financially Fabulous - YouTube

Welcome to LimorTV, the place to be learn about money and get inspired to take small

steps to improved your finances.

While I'm not a financial planner, I'll show you what I've learned.

In this episode, I'll be explaining nominal interest rate and effective interest rates.

Come on this will be fascinating.

Nominal and effective interest rates.

Let's decode this jargon.

Back to basics.

When you borrow money, whether it is on a credit card, a line of credit, a mortgage,

either way you are given an interest rate.

The interest rate is the proportion of the amount loaned which the lender charges the

borrower.

They aren't going to give you the money for free.

This amount is expressed as a percentage so basically, you have to pay a percent of what

you borrow as interest.

Being aware of the percentage is a good way to compare the cost of borrowing money from

different banks.

For example, if one credit card charges you 19.99% interest rate and another charges you

12.99% interest rate, then it is easy to see that the cost of borrowing money will be more

expensive on the credit card with 19.99% interest rate.

Hope you're with me so far!

Now, the amount of interest that a bank or a credit card provider gives you is called

APR.

Which is the annualized percentage rate or also known as the nominal interest rate.

This is the periodic interest multiplied by the number of periods in a year.

But what that really means is the amount of interest that you have to pay in a year if

the interest is only compounded or calculated once a year.

Hold on a second.

Let me re-cap.

Nominal interest rate is also APR and the amount of interest that you would pay over

a year if the interest is only compounded one time in a year.

These are the rates you'll see when you see the advertising commercials and you go into

the bank.

For example, you may see credit cards with 21% interest, line of credit with 6% interest

rate.

What you are being shown in the nominal rate.

So off you go, signing up with all of these great rates but what most of us don't realize

is that on these products interest rates aren't compounded just one time a year.

In fact, for most credit cards, interest rates are actually compounded or recalculated ever

single day.

The amount of interest you pay is based on the frequency of compounding.

This is called the effective interest rate.

So let's take a look at this together.

If you think that you are paying 10% interest on a credit card, which is typically compounding

daily, you're actually paying 10.52% just because of the fact that it is compounding

daily.

If you think that you are paying 20% interest on a credit card, again which typically compounds

daily, you're actually paying 22.13% While the little bit of extra percent doesn't seem

to make that much of a difference, just start to think about the impact it has if you owe

a lot of money.

By the way, this chart is in the downloadable so you can look at it more closely on your

own afterwards.

Let's say that you owe $20,000 with 20% APR, remember we learned that APR is the same as

the nominal interest rate.

You would pay $4,000 in interest a year.

But if you owed the same $20,000 on a credit card that compounded daily, you're effective

interest rate would be 22.13% which would mean that you would have to pay $4426.

That's an extra $426 to pay in interest.

This is why you can have the same interest rate on different products and be charged

different amounts.

If you have outstanding debt on a credit card, you may want to consider transferring it to

a line of credit or another credit product that has a lower interest rate and that perhaps

compounds less frequently.

That brings me to today's tweetable: Don't be fooled by advertiser's numbers, know your

effective rate!

Here is my challenge to you.

I want you to take a look at all of the outstanding money you owe on credit products, that could

be credit cards, lines of credit, mortgages etc.

And I want you to figure out how often the interest compounds for each of these.

Here's a hint, take a look at the fine print on your next monthly statement, call your

bank or just google the details of the specific product that you have.

Don't forget to access the free downloadable below at Limor.Money to help you track the

compounding frequency of your accounts.

Does it surprise you to know that the interest rates aren't really what they seem?

Leave a comment below letting me know what you think about effective interest rates.

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Did you learn something?

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Remember I'm not here to change who you are or how you live your life, I just have strategies

to make you even more financially fabulous.

Feel proud that you're learning and taking small steps to improve your finances, it will

give you more confidence and peace of mind.

Thank you so much for watching and I'll catch you next time on LimorTV.