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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 accounts for the effect of compounding interest, which the nominal rate does not.
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 results in a higher effective rate.
Details: Understanding the effective rate is crucial for comparing different financial products with the same nominal rate but different compounding frequencies. It shows the true cost of borrowing or 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, 1 for annual).
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 shows the actual financial impact.
Q2: How does compounding frequency affect the rate?
A: More frequent compounding (e.g., daily vs. monthly) results in a higher effective rate, all else being equal.
Q3: What's continuous compounding?
A: When compounding occurs constantly (n approaches infinity), the formula becomes e^(r) - 1, where e is Euler's number (~2.71828).
Q4: Why is the effective rate important for loans?
A: It helps borrowers compare different loan options that might have the same nominal rate but different compounding frequencies.
Q5: How is this used in investments?
A: Investors use it to compare returns on investments with different compounding periods to understand which offers better actual returns.