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Effective Interest Rate Formula:
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The Effective Interest Rate (also called Annual Equivalent Rate or AER) 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 accounts for the effect of compounding interest, unlike the nominal interest rate.
The calculator uses the effective interest rate formula:
Where:
Explanation: The formula shows how compounding frequency affects the actual interest earned or paid. More frequent compounding leads to higher effective rates.
Details: Understanding the effective rate is crucial for comparing financial products with different compounding periods. It shows the true cost of borrowing or true return on investment.
Tips: Enter the nominal 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: Nominal rate doesn't account for compounding, while effective rate does. For example, 10% nominal compounded quarterly gives an effective rate of 10.38%.
Q2: How does compounding frequency affect the rate?
A: More frequent compounding increases the effective rate. Daily compounding gives a higher effective rate than monthly compounding at the same nominal rate.
Q3: What's the effective rate for continuous compounding?
A: For continuous compounding, use er - 1 where e is Euler's number (~2.71828) and r is the nominal rate.
Q4: When is effective rate most important?
A: Most important when comparing loans or investments with different compounding periods, or when compounding is frequent (daily, continuous).
Q5: Can effective rate be lower than nominal rate?
A: No, effective rate is always equal to or greater than nominal rate when compounding occurs more than once per year.