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==Nominal versus effective interest rate==
The nominal interest rate is the periodic interest rate times the number of periods per year. For example, a nominal annual interest rate of 12% based on monthly [[Compound interest|compounding]] means a 1% interest rate per month (compounded).<ref> Charles Moyer, James R. McGuigan, William J. Kretlow. ''Contemporary Financial Management'', Tenth Edition. Thomson-South-Western, Mason, Ohio, 2006 [http://books.google.com/books?vid=ISBN0324289081&id=c8fOHam2S-MC&pg=PA163&lpg=PA163&ots=rEQQBn5LEU&dq=nominal+interest&sig=YsHcq0y9ZiOODUT2fZQwf7pxX_E pg. 163].</ref> A nominal interest rate for compounding periods less than a year is always lower than the equivalent rate with annual compounding (this immediately follows from elementary algebraic manipulations of the formula for compound interest). Note that a nominal rate without the compounding frequency is not fully defined: for any interest rate, the [[effective interest rate]] cannot be specified without knowing the compounding frequency ''and'' the rate. Although some conventions are used where the compounding frequency is understood, consumers in particular may fail to understand the importance of knowing the effective rate.
Nominal interest rates are not comparable unless their compounding periods are the same; [[effective interest rate]]s correct for this by "converting" nominal rates into annual compound interest. In many cases, depending on local regulations, interest rates as quoted by lenders and in advertisements are based on nominal, not effective interest rates, and hence may understate the interest rate compared to the equivalent effective annual rate.
The term should not be confused with simple interest (as opposed to
The [[effective interest rate]] is always calculated as if compounded annually. The effective rate is calculated in the following way, where r is the effective rate, i the nominal rate (as a decimal, e.g. 12% = 0.12), and n the number of compounding periods per year (for example, 12 for monthly compounding):
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