how to compute effective interest rate

Moreover, investment websites and other financial resources regularly publish the effective annual interest rate of a loan or investment. This figure is also often included in the prospectus and marketing documents prepared by the security issuers. The effective annual interest rate is important because borrowers might underestimate generally accepted accounting principles gaap the true cost of a loan without it. And investors need it to project the actual expected return on an investment, such as a corporate bond. That’s why the effective annual interest rate is an important financial concept to understand. You can compare various offers accurately only if you know their effective annual interest rates.

A short survey on bank interest rates

Understand the psychological marketing approach of communicating effective annual interest rates. The annual interest rate and effective interest rate can differ significantly due to compounding. The effective rate can help you figure out the best loan rate or which investment offers the best return. The table below shows the difference in the effective annual rate when the compounding periods change.

What the Effective Annual Interest Rate Tells You

  1. Even if the nominal rate is positive, inflation can erode purchasing power so far that money loses its value when held onto.
  2. To answer this question, you must convert the annual rates of each scenario into effective interest rates.
  3. The effective rate of interest is one of the easier financial calculations to make, but you still need an in-depth equation to figure it out.
  4. When compounding is taken into consideration, the EAR will always be higher than the stated annual interest rate.
  5. In this case the 3% stated interest rate is equal to a 3.04% effective interest rate.

Effective annual interest rate is the interest rate actually earned due to compounding. For example, for a deposit at a stated rate of 10% compounded monthly, the effective annual interest rate would be 10.47%. Banks will advertise the effective annual interest rate of 10.47% rather than the stated interest rate of 10%.

how to compute effective interest rate

Uses of Effective Annual Interest Rates

Investors, savers, or borrowers can take nominal rates with different compounding periods (i.e. one that compounds weekly, one that compounds monthly) to see which will be most beneficial to them. In this context, the EAR may be used as opposed to the nominal rate when communicate rates in an attempt to lure business of transactions. For example, if a bank offers a nominal interest rate of 5% per year on a savings account, and compounds interest monthly, the effective annual interest rate will be higher than 5%. Therefore, the bank should consider promoting the account at the EAR because that rate will appear higher.

Is It Better to Have a Higher EAR?

We can use EFFECT function in Microsoft Excel to calculate effective interest rate. Nominal rate is the stated annual rate quoted by the bank we discussed above and npery is the number of compounding periods per year. In case of the example above, you need to enter EFFECT(10%, 2) in the formula bar to get 10.25%. Note that the altering the buying power of the money also affects the real value of the interest you pay or receive, especially over a long period. When you adjust the nominal rate by inflation, you get to the concept of the real interest rate, which is an important measure in economics. We also recommend our Taylor rule calculator for a deeper dive into inflation, interest rates, and central bank policies.

When planning for long-term financial goals like retirement, real interest rates are more relevant as they incorporate eroding purchasing power. In addition, assessing international investments may call for real rates as different regions may be impacted by differing macroeconomic policies. If an investor were to put $5 million into one of these investments, the wrong decision would cost more than $5,800 per year. The Excel EFFECT function returns the effective annual interest rate, given a nominal interest rate and the number of compounding periods per year.

This is done to make consumers believe that they are paying a lower interest rate. The effective interest rate of 4%, compounded quarterly, is approximately 4.06% with a periodic rate of 1%. On the other hand, if compounded monthly, the effective interest rate would be approximately 4.074%, with a periodic rate of 0.3333%. The investment fund’s higher effective interest rate suggests that you would earn more interest in that case. Still, it can result in large differences in your investment’s future value in the longer-term. If you are curious how, try out our savings goal calculator, where you can follow the long-term progress of your savings.