What's the difference between APR and nominal

Knowing the difference between APR and nominal rates

Interest as many will know is the amount earned / paid on money saved or invested / borrowed. Think of it as the 'price' of money. In the following article we will consider a person looking to borrow an amount of money. When they are looking at interest rates they are considering how much will it cost me to borrow this amount.

Generally interest rates tend to be quoted in media in two different forms. These are the nominal rate or APR rate. Do not be confused by the two as they are not the same. It is always worth questioning which rate is being quoted to you. Is it the nominal rate or the APR rate?

What is nominal interest?

Nominal rate is the rate charged on the amount borrowed on a periodic basis. For example you go into your overdraft and the nominal rate might be 10% charged on a monthly basis. Let's say that you are £1,000 into your overdraft. You will be charged £100 in your first month meaning that your outstanding overdraft will be £1,100. Then if you fail to pay off your overdraft for a second month you will be charged another 10% nominal interest. £110 nominal interest charge will be added to your overdraft.

Nominal interest rates are quite easy to calculate. This is simply the outstanding debt balance multiplied by the nominal rate on the period upon which the interest is calculated. In our example this was over a month at a time.

What is APR interest?

Most financial products, particularly those advertised on TV quote an APR interest figure, normally at the bottom of the screen in small white writing.

APR stands for annual percentage rate. It is the interest rate considered over the period of a year. All nominal interest rates can be converted into an APR interest rate.

In our example of the nominal interest rates above you will have noticed that the second month interest charge was £110. This is £10 higher than the first month interest of £100. This is because during the second month interest was being charged also on the interest from the first month. This effect compounds month to month: charging interest on interest on the interest ad infinitum. 

If I were to ask you what is the interest rate for the whole year in our example I may receive different answers. Some will suggest it is 10% since I am being charged 10% per month. Some will guess 120% since I have been charged 10% for 12 months. Both are wrong. The answer is 314% is the effective interest rate (APR rate) charged for a while years borrowing of the nominal rate is 10% per month. This is due to the compounding effect of interest explained in the previous paragraph.

The APR rate can be calculated from the nominal rate as follows: 
£1,000 X ( 1 + 10% ) ^ 12 months

This equals £3,140 which is 314% increase on the original £1,000.

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