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Effective Rate Formula:
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The effective interest rate (also called effective annual rate or annual equivalent 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.
The calculator uses the effective rate formula:
Where:
Explanation: The formula accounts for the effect of compounding interest, which causes the effective rate to be higher than the nominal rate when compounding occurs more than once per year.
Details: Understanding the effective rate is crucial for comparing different mortgage or loan offers that may have the same nominal rate but different compounding frequencies. It represents the true cost of borrowing or the true return on investment.
Tips: Enter the nominal annual interest rate (as a percentage) and the number of compounding periods per year (e.g., 12 for monthly, 4 for quarterly, 365 for daily).
Q1: Why is effective rate different from nominal rate?
A: The effective rate accounts for compounding, while the nominal rate doesn't. More frequent compounding results in a higher effective rate.
Q2: How does compounding frequency affect the rate?
A: The more frequently interest is compounded, the higher the effective rate will be compared to the nominal rate.
Q3: What's the difference between APR and effective rate?
A: APR includes fees and other loan costs, while effective rate focuses purely on the impact of compounding on the interest rate.
Q4: When is the effective rate equal to the nominal rate?
A: Only when interest is compounded annually (n=1). In all other cases, the effective rate will be higher.
Q5: How important is this for mortgage comparisons?
A: Very important - mortgages with the same nominal rate but different compounding frequencies can have significantly different actual costs.