Effective Annual Rate

The effective annual interest rate is the actual rate of return received by investors or the actual interest rate paid on debt by borrowers.

What is the Effective Annual Rate?

The effective annual rate is the rate of interest actually earned on an investment or paid on a loan as a result of compounding the interest over a given period of time. It is usually higher than the nominal rate and is used to compare different financial products that calculate annual interest with different compounding periods – weekly, monthly, and yearly.  Extending the compounding periods makes the effective annual interest rate increase as time goes by.

The effective annual rate is higher than the nominal rate, because the nominal rate quotes a yearly percentage rate regardless of compounding. The compounding periods increases the effective annual rate as compared to the nominal rate. To spin it in another light, an investment that is compounded annually will have an effective annual rate that is equal to its nominal rate. However, if the same investment was instead compounded quarterly, the effective annual rate would then be higher.

What is the Formula for the Effective Annual Rate?

Effective Annual Rate = (1 + (nominal interest rate / number of compounding periods)) ^ (number of compounding periods) – 1

To Illustrate:

Union bank offers a nominal interest rate of 12% on its certificate of deposit to Mr. Obama, a bank client. The client initially invested $1,000 and agreed to have the interest compounded monthly for one full year. As a result of compounding, the effective interest rate is 12.683%, in which the money grew by $126.83 for one year, even though the interest is offered at only 12%.

What is a nominal interest rate?

A nominal interest rate is the stated rate indicated by a financial instrument that is issued by a lender or guarantor. This rate is the basis for computation to derive the interest amount resulting from compounding the principal plus interest over a period of time.  In essence, this is the actual monetary price that borrowers pay to lenders or that investors receive from issuers.

What is a Compounding Period?

A compounding period is the number of times that the outstanding loan or investment’s interest is added to the principal amount of said loan or investment. The period can be daily, weekly, monthly, quarterly, or semi-annually, depending on the terms agreed upon by the parties involved.  As the number of compounding periods increase, so does the amount of interest earned or paid on the money used. Quarterly compounding produces higher returns than semi-annual compounding, while monthly compounding does more than quarterly, and daily compounding does more than monthly.

How Important is the Effective Annual Rate in Business?

The effectual annual interest rate is a useful way of evaluating the actual return on investment and ascertaining the interest expense paid on a loan. Borrowers are keen on the impact cost of debt has on their business, because it will greatly affect the net earning potential. A high interest expense lowers the interest coverage ratio which in turn shows that the company is operating mostly by debt and might face a financial issue in the future. On the other hand, investors will benefit more if the effective interest rate is far greater than the nominal rate offered by the issuer. They also use this rate to compare various investment portfolios by using different compounding periods to make an effective decision.

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