Effective Interest Rate Calculator
Effective Interest Rate Formula
The formula for Effective Interest Rate (also referred to as Effective Annual Interest Rate, or EAR) is the following:
r = (1 + i/n)n-1
r = Effective Annual Rate
i = Nominal Rate
**Note: Nominal Interest Rate is the stated Intesest rate for the investment product.
n = Number of Compounding Periods per Year
What is Effective Interest Rate?
Firms and individual investors evaluate the Effective Interest Rate to anaylze the difference between financial products. The difference between the stated rate of two different investments can have a significant impact over a long-term investment, and the difference isn't always apparent. The difference is a result of how the interest is compounded. This measure is also used to evaluate an accurate Return on Investment.
It is important to note that financial institutions (such as banks and credit card companies) typically advertise the stated rate rather than the effective rate because the stated rate appears "lower," and this makes borrowers think that they are getting a better deal. For example, if a bank advertises loans with a stated rate of 23% compounding monthly, the effective interest rate is actually 25.586%; a borrower is paying almost 2.5% more than what is advertised as a result of compounding interest!
Alternatively, when a financial institution advertises for interest bearing accounts (such as a CD or savings account), they will typically advertise the effective annual rate rather than the stated interest rate because it is higher and appears to be a better investment. For example, a bank may offer a CD (Certificate of Deposit) with an effective rate of 7.229%, where the stated rate would be 7% assuming interest is compounded on a monthly basis. It is important to be aware of not only this tactic, but the fine print of any investment or loan, because there can be a substantial impact to long-term or high-value financial committments.
How to Find Effective Interest Rate
Jayden has $1,000 and he is going to put his money in a bank that is offering 7% and it is compounded monthly, what is his effective interest rate?
His effective interest rate is 7.229%.
In looking at this, if you were to just calculate how much interest he would earn based on simple interest at 7%, he would make $1070 after a year. However if you consider the effect of compounding interest, he actually will make $1072.29. While this isn't significant, every dollar counts and this will add up over time.