Accounting and Finance >> Time Value of Money
- Compounding is the process of reinvesting interest at the end of each period to allow interest to be earned on itself.
- Financial calculators may offer the option of either entering the Nominal Annual Rate or the Periodic Rate. Make sure you enter the rate correctly.
may be simple, or compounded. Simple interest is straight interest calculated as a percentage of the initial principal amount. This would occur, for example, when interest is earned on a single period, and not reinvested.
occurs when earned interest is reinvested and allowed to accumulate. This means interest is earned on interest, and not just the principal invested. As a consequence, your investment grows significantly larger, and faster than it would if it were only earning simple interest.
Since there is a specific vocabulary for interest rates, it is important to know the distinctions between the different terms. The Nominal Annual Rate
is the rate as stated or quoted per annum. It is NOT necessarily the rate used for each compounding period, and it is NOT necessarily the interest actually earned.
The interest rate used for each compounding period is referred to as the Periodic Interest Rate
. The rate is calculated by dividing the nominal annual rate by the number of compounding periods per year. For example, if the nominal annual rate were stated at 12%, then the interest rate per compounding period would be 1% (12% divided by 12 months per year).
The Effective Annual Rate
is the interest you actually earned over the year expressed as a percentage of the amount invested at the beginning of the year, regardless of the number of compounding periods during the year.
For example, if you invested $100 at 12% interest compounded monthly, you would have about $112.68 at the end of the year. That means your Effective Annual Rate is 12.68%. Compounding each month means you would actually have earned more than the 12% stated as the Nominal Annual Rate.