Effective interest rate

Compound Interest: Effective Rate of Interest and Nominal Rate of ...

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The effective interest rate (EIR), effective annual interest rate, annual equivalent rate (AER) or simply effective rate is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest payable in arrears.

It is used to compare the annual interest between loans with different compounding periods like week, month, year, etc. The effective interest rate differs in one important respect from the annual percentage rate (APR): the APR method converts this weekly or monthly interest rate into what would be called an annual rate that doesn't take into account the effect of compounding.

By contrast, in the EIR, the periodic rate is annualized using compounding. It is the standard in the European Union and a large number of countries around the world.

The EIR is more precise in financial terms, taking into consideration the effects of compounding, i.e. the fact that for each period, interest is not calculated on the principal, but on the amount of the previous period, including capital and interest. This reasoning is easily understandable when looking at savings: interest is capitalized every month, and every month the saver earns interest on the interest from the previous period. As an effect of compounding, the interest earned over a year represent 26.82% of the initial amount, instead of 24%, the monthly 2% interest rate simply multiplied by 12. If we consider borrowings instead of savings, the compounded interest rate reflects the opportunity cost for the borrower not to be able to invest the interest he pays to the lender into an asset generating the same percentage of return.

The term nominal EIR or nominal APR can be used to refer to an annualized rate that does not take into account front-fees and other costs can be included.

Annual percentage yield or effective annual yield is the analogous concept used for savings or investment products, such as a certificate of deposit. Since any loan is an investment product for the lender, the terms may be used to apply to the same transaction, depending on the point of view.

Effective annual interest or yield may be calculated or applied differently depending on the circumstances, and the definition should be studied carefully. For example, a bank may refer to the yield on a loan portfolio after expected losses as its effective yield and include income from other fees, meaning that the interest paid by each borrower may differ substantially from the bank's effective yield.

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Calculation

The effective interest rate is calculated as if compounded annually. The effective rate is calculated in the following way, where r is the effective annual rate, i the nominal rate, and n the number of compounding periods per year (for example, 12 for monthly compounding):

r\ =\ \left(1+{\frac {i}{n}}\right)^{n}-1

For example, a nominal interest rate of 6% compounded monthly is equivalent to an effective interest rate of 6.17%. 6% compounded monthly is credited as 6%/12 = 0.005 every month. After one year, the initial capital is increased by the factor (1 + 0.005)¹² ? 1.0617.

When the frequency of compounding is increased up to infinity the calculation will be:

r\ =\ e^{i}-1

The yield depends on the frequency of compounding:

The effective interest rate is a special case of the internal rate of return.

If the monthly interest rate j is known and remains constant throughout the year, the effective annual rate can be calculated as follows:

r\ =\ (1+j)^{12}-1

The annual percentage rate (APR) is calculated in the following way, where i is the interest rate for the period and n is the number of periods.

APR = i x n

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