1. What is Effective Interest Rate?

The effective interest rate (also known as annual equivalent rate) is the actual annual interest rate earned or paid on an investment or loan when compounding is taken into account. It provides a true comparison between different compounding frequencies.

2. How Does the Calculator Work?

The calculator uses the effective interest rate formula:

Where:

• \( r \) — Nominal annual interest rate (as a decimal)
• \( n \) — Number of compounding periods per year

Explanation: The formula accounts for the effect of compounding by calculating the interest earned on previously accumulated interest.

3. Importance of Effective Rate Calculation

Details: Understanding the effective rate is crucial for comparing different financial products, making informed investment decisions, and accurately assessing the true cost of borrowing or return on investment.

4. Using the Calculator

Tips: Enter the nominal annual interest rate as a percentage (e.g., 5 for 5%) and the number of compounding periods per year (e.g., 12 for monthly compounding, 4 for quarterly).

5. Frequently Asked Questions (FAQ)

Q1: What's the difference between nominal and effective rate?
A: Nominal rate doesn't account for compounding, while effective rate shows the actual annual rate including compounding effects.

Q2: How does compounding frequency affect the effective rate?
A: More frequent compounding results in a higher effective rate for the same nominal rate.

Q3: What are common compounding periods?
A: Annual (1), Semi-annual (2), Quarterly (4), Monthly (12), Weekly (52), Daily (365).

Q4: When is effective rate most important?
A: When comparing loans or investments with different compounding frequencies or when making long-term financial decisions.

Q5: Can effective rate be lower than nominal rate?
A: No, effective rate is always equal to or greater than the nominal rate due to compounding effects.