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What does 'Nominal' mean

Nominal means very small or far below the real value or cost, and in finance, this adjective modifies words such as fee, interest rate and gross domestic product (GDP). A nominal fee simply refers to a fee that is below the cost of the service provided or presumably easy for a consumer to afford. When describing concepts such as interest rate or GDP, nominal refers to their unadjusted rate, value or current price without taking elements such as inflation, seasonality, loan fees, interest compounding or other factors into account.

BREAKING DOWN 'Nominal'

In contrast to nominal, real expresses the value of something after making adjustments for various factors to create a more accurate measure. For example, the difference between nominal and real GDP is that nominal GDP measures the economic output of a country using current market prices, and real GDP takes inflation into account to create a more accurate measure.

Nominal vs. Real Rate of Return

The rate of return is the amount an investor earns on an investment. While the nominal rate of return reflects the investor's earnings as a percentage of his initial investment, the real rate takes inflation into account. As a result, the real rate gives a more accurate assessment of the actual buying power of the investor's earnings.

To illustrate, imagine you buy a $10,000 stock and sell it the following year for $11,000. Your nominal rate of return is 10%. However, to get a more accurate picture of your actual return, this rate needs to be adjusted for inflation, as the purchasing power of your money has likely changed over the one-year period. Therefore, if inflation for that year is 4%, the real rate of return is only 6%, or the nominal rate of return minus the rate of inflation.

Nominal vs. Real Interest Rates

Like the difference between nominal and real rates of return, the difference between nominal and real interest rates is that the latter is adjusted for inflation. However, in terms of interest, the nominal rate also contrasts with the annual percentage rate (APR) and the annual percentage yield (APY). In this case, the nominal or stated rate is the rate the lender advertises, and it is the basic interest rate the consumer pays on the loan.

APR, in contrast, takes into account fees and other costs associated with the loan, and it calculates the interest rate with those factors in mind. For example, imagine a borrower takes out a $1,000 loan with a 5% nominal interest rate, but he also pays a $100 origination fee. During the first year of the loan, he faces $50 in interest fees but when you take the origination fee into account, he pays $150 in fees and interest. This equates to a 15% APR. Conversely, APY takes both the fees and the effect of compounding into account to give the borrower an even more accurate picture of his interest rate.

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