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Effective Interest Rate Formula:
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The Effective Interest Rate (also known as Annual Equivalent Rate or AER) calculates the true annual interest rate when compounding is taken into account. It shows the actual return on an investment or cost of a loan when interest is compounded multiple times per year.
The calculator uses the Effective Interest Rate formula:
Where:
Explanation: The formula accounts for the effect of compounding, showing how interest earned on interest increases the effective rate compared to the nominal rate.
Details: Understanding the effective interest rate is crucial for comparing different financial products, making informed investment decisions, and accurately assessing the true cost of borrowing.
Tips: Enter the 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). All values must be valid (interest rate > 0, compounding frequency ≥ 1).
Q1: What's the difference between nominal and effective interest rates?
A: The nominal rate doesn't account for compounding, while the effective rate does. The effective rate is always equal to or higher than the nominal rate.
Q2: How does compounding frequency affect the effective rate?
A: More frequent compounding results in a higher effective interest rate, as interest is calculated on previously earned interest more often.
Q3: When is the effective interest rate most important?
A: It's most important when comparing financial products with different compounding periods, such as savings accounts, loans, or investment products.
Q4: Can the effective rate be lower than the nominal rate?
A: No, the effective rate is always equal to or greater than the nominal rate due to the effect of compounding.
Q5: How is this different from APR?
A: While similar, APR may include additional fees and costs, while AER/EIR focuses solely on the compounding effect of the interest rate itself.