Question

Describe the likely importance of the difference between nominal and effective interest rates from the perspective of an individual: 1) buying a new automobile using a 60-month installment loan, versus an individual 2) investing for their retirement in a 401k plan through their employer.

Answer 1

For an individual buying a new automobile through an installment loan, calculate the effective annual interest rate to know the true cost of the loan. This will help the individual in comparing various loan options available with the varied term and payment frequency.

On the other hand, for an employee who is investing in 401(K) has to assess the number of interest compounding in a year and calculate the effective return on his investment to compare with other investment options with varied term and compounding. This will help the individual in selecting the investment option that maximizes the true return.

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