What is the nominal interest rate?

The nominal interest rate is a type of money interest rate. This type of interest is the agreed interest that is due for a loan or that you receive for an investment. It does not include any additional costs such as consultancy fees. Usually, the interest rate is based on a period of one year. The abbreviation “p. a.” stands for “per year” and is derived from the Latin “per anno”.

Example: Simple Nominal Interest Calculation

Imagine borrowing an amount of 10,000 euros from a credit institution at a nominal interest rate of 4%. You have to pay 400 Euro interest per year. This amount does not cover any additional costs you may incur.

Difference between nominal and effective interest rate

The nominal interest rate may differ from the effective interest rate. The effective interest rate is the interest rate composed of the nominal interest rate and other components.

Depending on the context in which an interest rate is agreed, the effective interest rate may contain different additional costs. The nature of the agreed repayments and interest payments also plays a role.

Credit institutions may charge you for their processing costs. These processing costs are also included in the effective interest rate. In this case, the effective interest rate rises above the nominal interest rate.

When you borrow money, you should therefore not only pay attention to the nominal interest rate. Instead, consider the effective interest rate. This must also be specified.

Example: Consider processing fees

Look again at the example from the beginning. They borrow 10,000 euros and agree a nominal interest rate of 4%. According to this simple calculation, you pay 400 euros a year – but only the nominal interest is covered. Additional costs are often incurred.

Let’s say your bank also charges you a flat rate of 100 Euro processing fees per year. In this calculation example, you no longer pay 400 euros per year, but 500 euros effectively. 500 euros out of 10,000 euros is 5%. If there are no other direct or indirect costs, you pay an annual percentage rate of charge of 5%, although the nominal interest rate remains 4%.

Difference between nominal and real interest rate

The real interest rate also depends on the nominal interest rate. To determine the real interest rate, you must include the inflation rate in your calculation. The real interest rate can refer to past inflation (ex post) or to the expected future real interest rate (ex ante).

The real interest rate can be negative if the inflation rate is above the nominal interest rate.

Example: Rapid estimation of the real interest rate

Imagine you have invested your money in a bank and agreed a nominal interest rate of 5%. If the inflation rate is 2 %, this results in the following rough calculation:

5 – 2 = 3.

In this example, the real interest rate is close to 3%. The actual calculation of the real interest rate is much more complex – but in many cases this rough calculation allows an approximate idea of how high the real interest rate is or will be.

Fixed and flexible interest rate

The nominal interest rate can be either a fixed number or a flexible variable. A flexible interest rate is linked to another interest rate, such as the capital market interest rate. In contrast, a fixed (fixed) interest rate is indicated with a concrete number.

However, a fixed interest rate can also change. However, this change has been firmly agreed. For example, the interest rate may be 4 % in the first year, 4,5 % in the second year and 5 % in the third year. Such an agreement shall also be recorded in the written contract.