Table of Contents### Nominal Versus Effective Interest

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Interest can also be compounded within the year. For example, suppose that your $1,000 investment earns 10% compounded semiannually. At the end of the first 6 months, you receive $50 in interest (5% of the original investment). This $50 is reinvested, and for the second half of the year, you earn 5% of $1,050, or $52.50. Therefore, the total interest earned in the first year is $102.50. In other words, the interest rate appears to actually be 10.25%. So which is the correct interest rate, 10% or 10.25%?

To answer that question, you need to know about the two ways that most interest rates are most often quoted: