Effective interest rate

Definition

The effective interest rate (EIR) is the actual annual rate of interest earned or paid on an investment or loan after accounting for compounding. It provides a true reflection of the financial cost or benefit over a year.

5 Must Know Facts For Your Next Test

1. Effective interest rate accounts for the frequency of compounding periods within a year.
2. EIR is calculated using the formula: (1 + i/n)^(n*t) - 1, where i is the nominal rate, n is the number of compounding periods per year, and t is time in years.
3. The effective interest rate is always higher than or equal to the nominal (stated) interest rate when there are multiple compounding periods.
4. EIR allows investors and borrowers to compare different financial products with varying compounding frequencies on an equal basis.
5. Understanding EIR helps in making informed decisions about loans, investments, and savings options.

Review Questions

• What does the effective interest rate account for that the nominal interest rate does not?
• How do you calculate the effective interest rate from a given nominal rate and number of compounding periods?
• Why is it important to understand and use the effective interest rate when comparing financial products?

Related terms

Nominal Interest Rate:

The stated annual rate of interest before taking into account any compounding within that year.

Compounding Periods: The intervals at which interest is applied to an investment or loan's principal.

Annual Percentage Rate (APR): A standardized measure of the yearly cost of funds over the term of a loan, expressed as a percentage without accounting for compounding effects.