Two interest rates used in business loans are the nominal interest rate and the effective interest rate. The annual interest rate quoted by the bank is often called the nominal rate (nominal means in name only). The effective annual interest rate gives effect to the compounding of the nominal rate.
Assume a business borrows $100,000 for one year at an annual interest rate of 6 percent (the nominal interest rate). One alternative is that the bank charges 6 percent simple interest that is payable at the end of the year. In this case the business pays the bank $106,000 (which includes $6,000 interest) at the maturity date one year later.
Now here’s a twist that happens all the time: Instead of 6 percent simple interest that is figured once a year, assume that the bank quotes a 6 percent annual interest rate that is compounded quarterly, which means it wants to be paid interest every three months. Does this make a difference? It sure does, and it makes the calculation of interest more complicated.
When used in reference to an annual rate of interest, compounding refers to the frequency of charging (or earning) interest during the year. The annual rate has to be converted into the interest rate per period. Assuming the lender charges interest quarterly, the 6 percent annual rate is divided by four to get the 1.5 percent interest rate per quarter.
In the example, the business could pay $1,500 at the end of each quarter ($100,000 × 1.5 percent interest rate per quarter = $1,500 interest per quarter). This way, the bank collects interest income earlier and can put the money to work sooner. On the other hand, the main reason for quarterly compounding may be to raise the effective annual interest rate.
Suppose the business doesn’t want to pay interest quarterly; it prefers to make just one payment at the maturity date of the loan one year later. The bank readily agrees as long as the compounding effect is included in the payoff amount (maturity value) of the loan. The bank demands quarterly compounding, which means there are four interest periods during the year.