True or false: With the effective interest method, interest revenue differs between periods

The term “interest rate” is one of the most commonly used phrases in the fixed-income investment lexicon. The different types of interest rates, including real, nominal, effective, and annual, are distinguished by key economic factors, that can help individuals become smarter consumers and shrewder investors.

Different types of interest rates, such as real, nominal, effective, and annual, are set apart by critical economic factors.
The nominal interest rate, or coupon rate, is the actual price borrowers pay lenders, without accounting for any other economic factors.
The real interest rate accounts for inflation, giving a more precise reading of a borrower's buying power after the position has been redeemed.
The effective interest rate includes the impact of compounding, in which a bond might pay interest annually but compounds semiannually, increasing the overall return.

The nominal interest rate is the stated interest rate of a bond or loan, which signifies the actual monetary price borrowers pay lenders to use their money. If the nominal rate on a loan is 5%, borrowers can expect to pay $5 of interest for every $100 loaned to them. This is often referred to as the coupon rate because it was traditionally stamped on the coupons redeemed by bondholders.

The real interest rate is so named, because unlike the nominal rate, it factors inflation into the equation, to give investors a more accurate measure of their buying power, after they redeem their positions. If an annually compounding bond lists a 6% nominal yield and the inflation rate is 4%, then the real rate of interest is actually only 2%.

It’s feasible for real interest rates to be in negative territory if the inflation rate exceeds the nominal rate of an investment. For example, a bond with a 3% nominal rate will have a real interest rate of -1%, if the inflation rate is 4%. A comparison of real and nominal interest rates can be calculated using this equation:

$\begin{aligned} &\text{RR}=\text{Nominal Interest Rate }-\text{ Inflation Rate}\\ &\textbf{where:}\\ &\text{RR = Real Rate of Return}\\ \end{aligned}$

Several economic stipulations can be derived from this formula, which lenders, borrowers, and investors may utilize to cultivate more informed financial decisions.

Typically, when the inflation rates are negative (deflationary), real rates exceed nominal rights. But the opposite is true when inflation rates are positive.
One theory believes the inflation rate moves in tandem with nominal interest rates over time, meaning that real interest rates become stable over long time periods. Therefore, investors with longer time horizons may be able to more accurately assess their investment returns on an inflation-adjusted basis.

Investors and borrowers should also be aware of the effective interest rate, which takes the concept of compounding into account. For example, if a bond pays 6% annually and compounds semiannually, an investor who places $1,000 in this bond will receive $30 of interest payments after the first 6 months ($1,000 x .03), and $30.90 of interest after the next six months ($1,030 x .03). In total, this investor receives $60.90 for the year. In this scenario, while the nominal rate is 6%, the effective rate is 6.09%.

Mathematically speaking, the difference between the nominal and effective rates increases with the number of compounding periods within a specific time period.

The differences between nominal, real, and effective rates are important when it comes to loans. For example, a loan with frequent compounding periods will be more expensive than one that compounds annually, which is a vital consideration when shopping for mortgages.

Furthermore, a bond that pays just a 1% real interest rate may not adequately grow an investor’s assets over time. Simply put: interest rates effectively reveal the true return that will be posted by a fixed-income investment and the true cost of borrowing for individuals or businesses.

Investors who seek protection from inflation in the fixed-income arena may elect to consider Treasury Inflation-Protected Securities (TIPS), which pay interest rates that are indexed to inflation. Mutual funds investing in bonds, mortgages, and senior secured loans that pay floating interest rates, also periodically adjust with current rates.

When it comes to a bond’s interest rates, shrew investors know to look beyond nominal or coupon rates when considering their overall investment objectives. A qualified financial advisor can help investors navigate interest rates that keep up with inflation.

The effective interest method is an accounting practice used to discount a bond. This method is used for bonds sold at a discount or premium; the amount of the bond discount or premium is amortized to interest expense over the bond's life.

The effective interest method is used to discount, or write off, a bond.
The amount of the bond discount is amortized to interest expense over the bond's life. As a bond's book value increases, the amount of interest expense increases.
The effective interest method considers the impact of the bond purchase price rather than accounting only for its par value or face value.
For lenders or investors, the effective interest rate reflects the actual return far better than the nominal rate.
For borrowers, the effective interest rate shows costs more effectively.
Unlike the real interest rate, the effective interest rate does not account for inflation.

The preferred method for amortizing (or gradually expensing the discount on) a bond is the effective interest rate method. Under this method, the amount of interest expense in a given accounting period correlates with the book value of a bond at the beginning of the accounting period. Consequently, as a bond's book value increases, the amount of interest expense increases.

When a discounted bond is sold, the amount of the bond's discount must be amortized to interest expense over the life of the bond. When using the effective interest method, the debit amount in the discount on bonds payable is moved to the interest account. Therefore, the amortization causes interest expense in each accounting period to be higher than the amount of interest paid during each year of the bond's life.

For example, assume a 10-year $100,000 bond is issued with a 6% semi-annual coupon in a 10% market. The bond is sold at a discount for $95,000 on January 1, 2017. Therefore, the bond discount of $5,000, or $100,000 less $95,000, must be amortized to the interest expense account over the life of the bond.

The effective interest method of amortization causes the bond's book value to increase from $95,000 January 1, 2017, to $100,000 prior to the bond's maturity. The issuer must make interest payments of $3,000 every six months the bond is outstanding. The cash account is then credited $3,000 on June 30 and December 31.

The effective interest method is used when evaluating the interest generated by a bond because it considers the impact of the bond purchase price rather than accounting only for par value.

Although some bonds pay no interest and generate income only at maturity, most offer a set annual rate of return, called the coupon rate. The coupon rate is the amount of interest generated by the bond each year, expressed as a percentage of the bond's par value.

Par value, in turn, is simply another term for the bond's face value, or the stated value of the bond at the time of issuance. A bond with a par value of $1,000 and a coupon rate of 6% pays $60 in interest each year.

A bond's par value does not dictate its selling price. Bonds that have higher coupon rates sell for more than their par value, making them premium bonds. Conversely, bonds with lower coupon rates often sell for less than par, making them discount bonds. Because the purchase price of bonds can vary so widely, the actual rate of interest paid each year also varies.

If the bond in the above example sells for $800, then the $60 interest payments it generates each year represent a higher percentage of the purchase price than the 6% coupon rate would indicate. Although both the par value and coupon rate are fixed at issuance, the bond pays a higher rate of interest from the investor's perspective. The effective interest rate of this bond is $60 / $800 or 7.5%.

If the central bank reduced interest rates to 4%, this bond would automatically become more valuable because of its higher coupon rate. If this bond then sold for $1,200, its effective interest rate would sink to 5%. While this is still higher than newly issued 4% bonds, the increased selling price partially offsets the effects of the higher rate.

In accounting, the effective interest method examines the relationship between an asset's book value and related interest. In lending, the effective annual interest rate might refer to an interest calculation wherein compounding occurs more than once a year. In capital finance and economics, the effective interest rate for an instrument might refer to the yield based on the purchase price.

All of these terms are related in some way. For example, effective interest rates are an important component of the effective interest method.

An instrument's effective interest rate can be contrasted with its nominal interest rate or real interest rate. The effective rate takes two factors into consideration: purchase price and compounding. For lenders or investors, the effective interest rate reflects the actual return far better than the nominal rate. For borrowers, the effective interest rate shows costs more effectively. Put another way, the effective interest rate is equal to the nominal return relative to the actual principal investment. In terms of accounting for bonds, the effective interest rate is the same as a bond's yield at the issue date.

An interest-bearing asset also has a higher effective interest rate as more compounding occurs. For example, an asset that compounds interest yearly has a lower effective rate than an asset that compounds monthly.

Unlike the real interest rate, the effective interest rate does not take inflation into account. If inflation is 1.8%, a Treasury bond (T-bond) with a 2% effective interest rate has a real interest rate of 0.2% or the effective rate minus the inflation rate.

The effective interest rate is a more accurate figure of actual interest earned on an investment or the interest paid on a loan.

The primary advantage of using the effective interest rate is simply that it is a more accurate figure of actual interest earned on a financial instrument or investment or of actual interest paid on a loan, such as a home mortgage.

The effective interest rate calculation is commonly used in relation to the bond market. The calculation provides the real interest rate returned in a given period, based on the actual book value of a financial instrument at the beginning of the period. If the book value of the investment declines, then the interest earned will decline also.

Investors and analysts often use effective interest rate calculations to examine premiums or discounts related to government bonds, such as the 30-year U.S. Treasury bond, although the same principles apply to corporate bond trades. When the stated interest rate on a bond is higher than the current market rate, traders are willing to pay a premium over the face value of the bond. Conversely, whenever the stated interest rate is lower than the current market interest rate for a bond, the bond trades at a discount to its face value.

The effective interest rate calculation reflects actual interest earned or paid over a specified timeframe. It is considered preferable to the straight-line method of figuring premiums or discounts as they apply to bond issues because it is a more accurate statement of interest from the beginning to the end of a chosen accounting period (the amortization period).

On a period-by-period basis, accountants regard the effective interest method as far more accurate for calculating the impact of an investment on a company's bottom line. To obtain this increased accuracy, however, the interest rate must be recalculated every month of the accounting period; these extra calculations are a disadvantage of the effective interest rate. If an investor uses the simpler straight-line method to calculate interest, then the amount charged off each month does not vary; it is the same amount each month.

Whenever an investor buys, or a financial entity such as the U.S. Treasury or a corporation sells, a bond instrument for a price that is different from the bond's face amount, the actual interest rate earned is different from the bond's stated interest rate. The bond may be trading at a premium or at a discount to its face value. In either case, the actual effective interest rate differs from the stated rate. For example, if a bond with a face value of $10,000 is purchased for $9,500 and the interest payment is $500, then the effective interest rate earned is not 5% but 5.26% ($500 divided by $9,500).

For loans such as a home mortgage, the effective interest rate is also known as the annual percentage rate. The rate takes into account the effect of compounding interest along with all the other costs that the borrower assumes for the loan.