Calculating Nominal and Effective Rates (APY) of Interest

Introduction

Nominal Rate (stated rate) is defined as the rate on which the bank calculates interest.
Effective rate (APY) = Interest rate for 1 year ÷ Principal

Calculating Effective Rate APY

Let's see the two following examples of calculating effective rate APY:
Example 1: 12% compounded quaterly; Principal = $4,000
N = 4 × 1 = 4 periods; Percent = 12% / 4 = 3%; Table factor (4 periods; 3%)=1.1256;
Compounded Amount = $4,000 × 1.1256 = $4,502.40; Interest for 1 year = Compounded Amount - Principal = $4,502.40 − $4,000= $502.40
Effective rate (APY) = $502.40 / $4,000 = 0.1256 = 12.56%

Example 2: Now, let's see the value of the effective rate (APY) if it's compounded semiannually:
N = 2 × 1 = 2 periods; Percent = 12% / 2 = 6%; Table factor (2 periods; 6%)=1.1236;
Compounded Amount = $4,000 × 1.1236 = $4,494.40; Interest for 1 year = Compounded Amount − Principal = $4,494.40 − $4,000= $494.40
Effective rate (APY) = $494.40 / $4,000 = 0.1236 = 12.36%

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Date of last modification: March 11, 2019