finance   Effective Interest Rate

Definition of Effective Interest Rate

The Effective interest rate or annual equivalent rate (AER) is the calculations of interest rate on the loan or certain investments or financial product if compounding happens more than one in a year, then the nominal interest rate restates as an interest rate on all debts.

The usage:

  • The utilization of this method is being recorded when the comparison came in between loan which consists different compounding terms (such as monthly, yearly, quarterly, and daily).
  • Another practical usage of Effective interest rate is on savings and investment products, for example the certificate of deposit. 

The difference between annual percentage rate and Effective interest rate or Effective Rate-

Effective interest rate differs from two different areas from annual percentage rate,

  • The first one is on usual basis Effective interest rate does not support one-time charges such as front-end fees.
  • On the second one, Effective interest rate is not used by legal and regulatory authorities.

The calculation of Effective interest rate is defined by the equation, which is

Books on Effective Interest Rate

Book 1:

Advanced Algebra with the TI-84 Plus Calculator By Brendan Kelly (published by Brendan Kelly Publishing Inc., 2007)

Book 2:

Corporate Finance By Peter Moles, Robert Parrino, David S. Kidwell (published by John Wiley & Sons, 2011)

How Effective Interest Rate works?

Here are two of practical examples that cater a good quality notion on the Effective interest rate,

  • Suppose there is predetermined annual rate of 10%, let’s say according to compounding the interest rate will turn the $1000 into $1100. If the compounding happens monthly on interest rate, then the principle of $1000 will become $1104.70 by the end of the year. As a consequence, the interest will be counted as 10.47%, not 10%.
  • Let’s say a person buy a certificate of deposit on predetermined interest rate of 12% from a bank, if compounding happens in every month (12 times in year) in the bank then according to the formula above the interest will become,

(1 + .12/12)12 - 1 = .12683 or 12.683%

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