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Nominal Rate of Return Definition
The Nominal Rate of Return is the rate of return on an investment before factoring in the expenses related to inflations, taxes and investment fees. The dollar amount of the return is compared to the investment amount to get the nominal rate of return. The return amount is not adjusted for inflation, tax expense or investment fees.
A Little More on the Nominal Rate of Return
It is important for an investor to look beyond the nominal rate of return to understand the real profitability of an investment. If the nominal rate of an investment is 8% and the inflation rate is 4% then the real rate of interest is only 4%.
Similarly, if a municipal bond and a corporate bond offer the same nominal rate of return that doesn’t necessarily means the return is the same for both. Usually, the income from the municipal bond is tax exempted but the income from the corporate bond is taxable. So, with the equal nominal rate of return, the municipal bond earns more return than the corporate bonds.
The after-tax rates of return may significantly differ from the nominal rate. The amount of tax of an investment depends on the nature of the investment, time period of investment and the tax bracket the investor falls into. Thus, the after-tax rate of return may vary from one investor to another even if the investment amount, time and nominal rate of return are the same for both.
The real rate of return is calculated by deducting the inflation rate from the nominal rate of return. However, the real rate of return doesn’t take into account the expenses caused by taxation.
The formula used for calculating real rate of return is,
Real rate of return = (1+ nominal rate) / (1+ inflation rate) – 1
If the nominal rate of return is 9% and the inflation rate is 2%, the real rate of return would be,
(1+0.09) / (1+0.02) -1
=1.09/1.02 – 1
=0.069 or 6.9%
The effective rate of return of an investment is calculated by factoring-in compounding effect. When the interest of an investment accumulates on one another the compounding occurs. The interest is calculated on that accumulated amount.
The formula for calculating the effective rate of return is,
Effective rate of return = ((1 + i/ n) n-1
Here, i denotes the annual interest rate or the nominal rate of return and n indicates the number of compounding periods in a year.
References for Nominal Interest Rate