If interest on an investment account is compounded semiannually, how does the effective rate of interest compare to the nominal rate?

When interest on an investment account is compounded semiannually, the effective interest rate is indeed higher than the nominal rate. This is because the nominal rate does not take into account the effects of compounding during the year.

Compounding semiannually means that interest is calculated and added to the principal twice a year. As a result, each time interest is added, the new amount generates further interest in subsequent periods. This leads to a growth effect that is not captured by simply assessing the nominal interest rate, which represents the annual rate without considering the compounding frequency.

To better understand this, it's useful to think of two concepts: nominal interest and effective interest. The nominal rate might state a certain percentage return annually (e.g., 6% nominal interest), while the effective rate will be higher due to the additional interest earned on interest over the semiannual periods. Therefore, the effective rate reflects the true return realized by the investor, accounting for these compounding periods, leading to a higher effective interest rate compared to the nominal rate.