What is the difference between nominal and effective rates?
A. A nominal rate is the “raw” value that is used to compute interest. An effective rate represents the “true” amount that the principal grows by. For example, if a nominal rate were defined as 10% compounded annually, but there were monthly contributions … then the calculator would actually compound at 0.10/12 or 0.833% monthly, to account for the contributions. Due to the nature of compounding, it actually amounts to a growth of 10.47% annually. If the same scenario were considered with a 10% effective annual rate, then the monthly compounding rate would only be 0.797%. It would result in the principal growing by exactly 10% annually.
