There are two primary ways to express an interest rate, whether it’s for saving or borrowing: with a nominal interest rate or an effective interest rate. Nominal interest doesn’t take compounding into account, while effective interest does.
But, uh, what is compounding?
You might remember hearing about compounding back in high school algebra (sorry to bring that up). But in case you’ve forgotten (we don’t blame you), let’s refresh.
Compounding basically means that interest gets calculated on your money, and then that interest gets added to your principal (the initial amount of money). So the next time interest gets calculated, it will be a percentage of both your principal and your previous interest.
Different banks and lenders compound interest at different frequencies. The compounding period, or the time between interest calculations, describes this frequency.
Sometimes interest gets compounded quite frequently, but that’s not always the case. In fact, all of the following are common compounding periods:
So if you have daily compounding interest, your interest will get calculated every day. If you have semiannually compounding interest, it only gets calculated every six months.
Your compounding period can make a big difference in your effective interest, but we’ll get to that in a minute. For now, back to nominal and effective interest.