Finance:Effective interest rate
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The effective interest rate (EIR), effective annual interest rate, annual equivalent rate (AER) or simply effective rate is the percentage of interest on a loan or financial product if compound interest accumulates over a year during which no payments are made. It is the compound interest payable annually in arrears, based on the nominal interest rate. It is used to compare the interest rates between loans with different compounding periods.
Depending on the jurisdictional definition, the effective interest rate may be higher than the annual percentage rate (APR), since the APR method reflects the annual total interest charge assuming periodic interest is paid as soon as it accrues and does not take compounding into account. By contrast, the EIR annualizes the periodic rate with compounding by computing the effects of compounding assuming no periodic payment of interest, so that future interest accrues on both the principal and the current interest. EIR is the standard in the European Union and many other countries, while APR is often used in the United States.
Annual percentage yield or effective annual yield is the analogous concept for savings or investments, such as a certificate of deposit. Since a loan by a borrower is an investment for the lender, both terms can apply to the same transaction, depending on the point of view. For a zero-coupon bond such as a US treasury bill, an annual effective discount rate may be specified instead of an effective interest rate, because zero coupon bonds trade at a discount from their face values.
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):
- [math]\displaystyle{ r \ = \ \left(1+\frac{i}{n}\right)^n - 1 }[/math]
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. Note that the yield increases with the frequency of compounding.
When the frequency of compounding is increased up to infinity (as for many processes in nature) the calculation simplifies to:
- [math]\displaystyle{ r \ = \ e^i - 1 }[/math]
where [math]\displaystyle{ e\approx 2.72 }[/math] is Euler's mathematical constant.
| Nominal annual rate |
Frequency of compounding | ||||
|---|---|---|---|---|---|
| Semi-annual | Quarterly | Monthly | Daily | Continuous | |
| 1% | 1.003% | 1.004% | 1.005% | 1.005% | 1.005% |
| 5% | 5.063% | 5.095% | 5.116% | 5.127% | 5.127% |
| 10% | 10.250% | 10.381% | 10.471% | 10.516% | 10.517% |
| 15% | 15.563% | 15.865% | 16.075% | 16.180% | 16.183% |
| 20% | 21.000% | 21.551% | 21.939% | 22.134% | 22.140% |
| 30% | 32.250% | 33.547% | 34.489% | 34.969% | 34.986% |
| 40% | 44.000% | 46.410% | 48.213% | 49.150% | 49.182% |
| 50% | 56.250% | 60.181% | 63.209% | 64.816% | 64.872% |
The effective interest rate is a special case of the internal rate of return.
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 × n
Effective interest rate (accountancy)
In accountancy, the term effective interest rate is used to describe the rate used to calculate interest expense or income under the effective interest method.[citation needed] This is not the same as the effective annual rate, and is usually stated as an APR rate.
See also
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