I. Based On Calculation Method
1. Simple Interest
Interest is calculated only on the original principal.2. Compound Interest
Interest is calculated on both the principal and previously accrued interest.
See other sections for detailed explanations.
II. Based On Timing & Adjustments (Common Rates)
1. Nominal interest rate The stated interest rate. It is the rate usually stated in advertisements. The stated rate of interest does not take into account compounding.
2. Annual Percentage Rate (APR)
The APR is the annual rate charged for borrowing or earned through an investment, including fees and other costs, but not accounting for compounding. It is essentially the nominal rate plus the effect of upfront fees (like loan origination, points, some closing costs), spread over the life of the loan.
1. Central Bank Rates
A. Federal Funds Rate (U.S.)
B. Discount Rate
3. Effective interest rate
The true interest being charged or earned which accounts for compounding. This is also known as the effective annual interest rate. When interest compounds—interest accrues on the previously earned interest—the total interest amount can increase. And the rate of compounding—such as daily, monthly, quarterly or annually—affects how quickly the interest accrues.
Example 1 (annual compounding)
Suppose you open a 12-month certificate of deposit (CD) with a 5% interest rate and deposit $10,000. If the interest compounds annually, you’ll have $10,500 at the end of the year—the 5% nominal interest rate is the same as the effective annual interest rate.Example 2 (monthly compounding)
Consider if the interest compounds monthly. You earn $41.67 at the end of the first month, and the 5% interest rate applies to your new $10,041.67 balance for month two. It keeps compounding, and by the end of the year, you will have $10,511.62. The nominal rate is still 5%. But your effective annual interest rate is 5.116% because that reflects how much interest you actually earned over the year.
Effective annual interest rate formula
The effective rate or effective annual is used to compare the interest rates between loans with different compounding periods. The formula for calculating the effective annual interest rate is:
r = (1 + i/n)ⁿ - 1
r = effective annual interest rate
i = nominal interest rate written as a decimal
n = compounding periods per year
Example 1
What is the effective annual interest rate for 6% compounded monthly?
r = (1 + 0.06/12)¹² - 1
r = (1 + 0.005)¹² - 1
r = (1.005)¹² - 1
r = 1.0617 - 1
r = 0.0617 = 6.17%
To drive the lesson home, here is a future value calculation for $1000 invested for one year at an annual interest rate of 6% compounded monthly
Notice that the interest for any period divided by the beginning balance for that period is the nominal interest rate of 6% but if you take the total interest for the year of $61.68 and divide it by the beginning investment of $1000 you get .06168 rounded to three decimal places equals .0617 = 6.17%. The same as the answer above.
4. Real Interest Rate
The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.The most common and straightforward way to calculate the real interest rate is using the Fisher equation. The approximate formula is:
For a more precise calculation, especially with higher inflation rates, the exact formula is:
III. Rate Behavior
1. Fixed Interest Rate
Stays constant for the loan/investment term.
2. Variable (Floating) Interest Rate
Fluctuates over time based on a benchmark (e.g., SOFR, Prime).
3. Adjustable Rate
Hybrid: Often fixed for a period, then becomes variable
IV. By Benchmark or Source
1. Central Bank Rates
A. Federal Funds Rate (U.S.)
B. Discount Rate
rate charged by the central bank to commercial banks
2. Interbank Rates
A. Secured Overnight Financing Rate (SOFR)
B. EURIBOR, SONIA
A. Secured Overnight Financing Rate (SOFR)
B. EURIBOR, SONIA
(used internationally)
3. Prime Rate
Set by banks as a base rate for best customers; often used as a benchmark for loans.
V. Economic Function
1. Discount Rate
Used to determine the present value of future cash flows (time value of money).
3. Prime Rate
Set by banks as a base rate for best customers; often used as a benchmark for loans.
V. Economic Function
1. Discount Rate
Used to determine the present value of future cash flows (time value of money).
2. Internal Rate of Return (IRR)
Used in investment decision-making to measure project profitability.
Used in investment decision-making to measure project profitability.
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