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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 calculating what the annual rate would be if interest were compounded only once per year, giving the true annual yield.
Details: AER is crucial for comparing different financial products with different compounding frequencies. It allows consumers and investors to make apples-to-apples comparisons between loans, savings accounts, and investments with varying compounding schedules.
Tips: Enter the annual nominal interest rate as a percentage (e.g., 5 for 5%), and the number of compounding periods per year (e.g., 12 for monthly compounding). The calculator will show the effective annual rate that accounts for compounding effects.
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 cost or return including compounding effects.
Q2: How does compounding frequency affect the effective rate?
A: More frequent compounding results in a higher effective rate for the same nominal rate, as interest is earned on interest more often.
Q3: When is AER most important to consider?
A: When comparing financial products with different compounding frequencies, or when evaluating long-term investments where compounding has significant effects.
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 compounding effect.
Q5: Is AER the same as APR?
A: While related, APR (Annual Percentage Rate) typically includes fees and other costs, while AER focuses solely on the interest compounding effect.