The amount of interest you would have to pay on a loan or would earn on an inves

tment is clearly an important consideration when making any financial decisions.

However, it is not enough to simply compare the nominal values of two interest
rates to see which is higher.
Effective Interest Rates
The reason why the nominal interest rate is only part of the story is due to com
pounding. Since interest compounds, the amount of interest actually accrued may
be different than the nominal amount. The last section went through one method f
or finding the amount of interest that actually accrues: the Effective Annual Ra
te (EAR).
The EAR is a calculation that account for interest that compounds more than one
time per year. It provides an annual interest rate that accounts for compounded
interest during the year. If two investments are otherwise identical, you would
naturally pick the one with the higher EAR, even if the nominal rate is lower.
Real Interest Rates
Interest rates are charged for a number of reasons, but one is to ensure that th
e creditor lowers his or her exposure to inflation. Inflation causes a nominal a
mount of money in the present to have less purchasing power in the future. Expec
ted inflation rates are an integral part of determining whether or not an intere
st rate is high enough for the creditor.
The Fisher Equation is a simple way of determining the real interest rate, or th
e interest rate accrued after accounting for inflation. To find the real interes
t rate, simply subtract the expected inflation rate from the nominal interest ra
te.
Fisher Equation
The nominal interest rate is approximately the sum of the real interest rate and
inflation.
For example, suppose you have the option of choosing to invest in two companies.
Company 1 will pay you 5% per year, but is in a country with an expected inflat
ion rate of 4% per year. Company 2 will only pay 3% per year, but is in a countr
y with an expected inflation of 1% per year. By the Fisher Equation, the real in
terest rates are 1% and 2% for Company 1 and Company 2, respectively. Thus, Comp
any 2 is the better investment, even though Company 1 pays a higher nominal inte
rest rate.
Cost of Capital
Another major consideration is whether or not the interest rate is higher than y
our cost of capital. The cost of capital is the rate of return that capital coul
d be expected to earn in an alternative investment of equivalent risk. Many comp
anies have a standard cost of capital that they use to determine whether or not
an investment is worthwhile.
In theory, a company will never make an investment if the expected return on the
investment is less than their cost of capital. Even if a 10% annual return soun
ds really nice, a company with a 13% cost of capital will not make that investme
nt.

Source: Boundless. Calculating Values for Fractional Time Periods. Boundless Accou
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ctional-time-periods-316-1470/
Source: Boundless. Loans and Loan Amortization. Boundless Accounting. Boundless, 2
1 Jul. 2015. Retrieved 25 Sep. 2015 from https://www.boundless.com/accounting/te
xtbooks/boundless-accounting-textbook/the-time-value-of-money-10/additional-deta
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Source: Boundless. Comparing Interest Rates. Boundless Accounting. Boundless, 21 J
ul. 2015. Retrieved 25 Sep. 2015 from https://www.boundless.com/accounting/textb
ooks/boundless-accounting-textbook/the-time-value-of-money-10/additional-detailon-present-and-future-values-68/comparing-interest-rates-318-1469/