There are essentially three main types of interest rates: the nominal interest rate, the effective rate, and the real interest rate.
The nominal interest of an investment or loan is simply the stated rate on which interest payments are calculated. Essentially, this is the rate on which savings accrue interest over a period of time. For example, an investment of EUR 10,000, at a nominal interest rate of 5% over 1 year, would earn the investor EUR 500.
The effective interest rate (AER) takes into account compounding over the full term of the investment. It is often used to compare the annual interest rates with different compounding terms (daily, monthly, annually, etc.). This means that a nominal interest rate of 5% compounded quarterly would equate to an effective rate of 5.095%, compounded monthly at 5.116%, and daily at 5.127%.
Finally, the real interest rate is useful when considering the impact of inflation on nominal interest rates. In essence, the real interest rate deducts the rate of inflation from the nominal interest rate. This means that if the nominal interest rate is 5% and the inflation rate is also 5%, the real interest rate is effectively 0%.
