If a loan has interest compounded monthly, how will the effective interest rate differ from the nominal rate?

When a loan has interest compounded monthly, the effective interest rate will indeed be higher than the nominal rate due to the effects of compounding. The nominal interest rate is the stated rate on the loan, which does not account for how often interest is applied to the outstanding balance. In contrast, the effective interest rate takes into account the frequency of compounding.

Compounding monthly means that interest is calculated and added to the principal balance each month, which results in interest being charged on interest in subsequent periods. Therefore, even if the nominal rate remains the same, the effective rate rises because more interest is effectively being charged over the year than would be indicated by the nominal rate alone.

Understanding this concept is crucial for borrowers, as it affects the total cost of borrowing and helps in comparing different loans with varying compounding frequencies. Thus, the relationship between the nominal interest rate and the effective interest rate is fundamental in finance and mortgage calculations.