National Council of Examiners for Engineering and Surveying (NCEES) Fundamentals of Engineering (FE) Chemical Practice Exam

When interest is compounded monthly, it is necessary to adjust the nominal interest rate to reflect the monthly compounding periods. This adjustment is made by dividing the nominal annual interest rate by the number of compounding periods per year—in this case, 12 months.

Thus, if you have an annual nominal interest rate, say 6%, and you are compounding monthly, the effective interest rate for each month would be 0.5% (which comes from dividing 6% by 12). This is crucial for calculating the future value of an annuity since the time value of money is influenced by the frequency of compounding.

This adjustment ensures that the calculations for annuity payments reflect the true cost of borrowing or the true yield on an investment, taking into account the number of times interest is applied throughout the year. By applying this monthly interest rate, one can accurately compute monthly annuity payments or the total value of the investment at maturity.