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Effective Annual Rate Formula:
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The Effective Annual Rate (AER) or Annual Equivalent Rate represents the actual annual interest rate when compounding is taken into account. It provides a more accurate measure of the true cost of borrowing or the true return on investment compared to the nominal interest rate.
The calculator uses the AER formula:
Where:
Explanation: The formula accounts for the effect of compounding by showing how interest is added to the principal at each compounding period, resulting in a higher effective rate than the nominal rate.
Details: Calculating the effective annual rate is crucial for comparing different loan or investment products with different compounding frequencies. It helps borrowers and investors understand the true cost or return of financial products.
Tips: Enter the annual nominal interest rate as a percentage (e.g., 5 for 5%) and the number of compounding periods per year. All values must be valid (interest rate > 0, compounding frequency ≥ 1).
Q1: What's the difference between nominal rate and effective rate?
A: The nominal rate doesn't account for compounding, while the effective rate shows the actual annual rate when compounding is considered.
Q2: How does compounding frequency affect the effective rate?
A: More frequent compounding results in a higher effective rate, as interest is calculated and added to the principal more often.
Q3: When is AER most important to calculate?
A: When comparing loans or investments with different compounding periods, or when the compounding frequency is more than annual.
Q4: Can AER be lower than the nominal rate?
A: No, AER is always equal to or higher than the nominal rate due to the effect of compounding.
Q5: How is AER used in financial decision-making?
A: It helps consumers make informed choices by providing a standardized way to compare financial products with different interest structures.