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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 return on investment compared to the nominal interest rate.
The calculator uses the Effective Annual Rate formula:
Where:
Explanation: The formula accounts for the effect of compounding, showing how interest earned on interest increases the effective rate above the nominal rate.
Details: AER is crucial for comparing different financial products with varying compounding frequencies. It helps investors and borrowers understand the true annual cost or return, enabling better financial decision-making.
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 positive numbers.
Q1: What's the difference between nominal and effective interest rate?
A: Nominal rate is the stated annual rate without compounding, while effective rate includes the effect of compounding throughout the year.
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: What are typical compounding frequencies?
A: Common frequencies include annually (1), semi-annually (2), quarterly (4), monthly (12), and daily (365).
Q4: When is AER most important to consider?
A: When comparing loans, savings accounts, or investments with different compounding periods, AER provides an apples-to-apples comparison.
Q5: Can AER be lower than the nominal rate?
A: No, AER is always equal to or higher than the nominal rate due to the compounding effect.