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Effective Interest Rate Formula:
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The effective interest rate (also called the equivalent annual rate) is the actual interest rate that is earned or paid on an investment, loan, or other financial product due to compounding over a given period. It shows the true cost or return of financial products.
The calculator uses the effective interest rate formula:
Where:
Explanation: The formula accounts for the effect of compounding, showing how more frequent compounding leads to higher effective returns.
Details: Comparing financial products requires understanding their true cost or return. The effective rate allows accurate comparison between products with different compounding frequencies.
Tips: Enter the nominal annual interest rate as a percentage (e.g., 5 for 5%) and the number of compounding periods per year (e.g., 12 for monthly compounding).
Q1: What's the difference between nominal and effective rate?
A: The nominal rate doesn't account for compounding, while the effective rate does. The effective rate is always equal to or higher than the nominal rate.
Q2: How does compounding frequency affect the effective rate?
A: More frequent compounding (e.g., daily vs. monthly) results in a higher effective rate, as interest is earned on interest more often.
Q3: What is continuous compounding?
A: Continuous compounding uses the formula e^(r) - 1, where e is Euler's number (~2.71828) and r is the nominal rate. It's the theoretical maximum effective rate.
Q4: When is this calculation most important?
A: When comparing loans or investments with different compounding periods, or when evaluating the true cost of credit.
Q5: Does this apply to both loans and investments?
A: Yes, the same formula works for both - showing either the true cost of borrowing or the true return on investment.