1. What is Effective Interest Rate?

The effective interest rate (also known as annual equivalent rate) is the actual interest rate earned or paid on an investment or loan when compounding is taken into account. It provides a more accurate measure of the true cost or return than the nominal rate.

2. How Does the Calculator Work?

The calculator uses the effective interest rate formula:

Where:

• \( r \) — Nominal interest rate (as a decimal)
• \( n \) — Number of compounding periods per year

Explanation: The formula accounts for the effect of compounding, showing how interest earned on interest increases the overall return compared to simple interest.

3. Importance of Effective Rate Calculation

Details: Understanding the effective rate is crucial for comparing different savings accounts, investments, or loans with varying compounding frequencies. It helps consumers make informed financial decisions.

4. Using the Calculator

Tips: Enter the 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). Both values must be positive numbers.

5. Frequently Asked Questions (FAQ)

Q1: What's the difference between nominal and effective rate?
A: Nominal rate doesn't account for compounding, while effective rate shows the actual annual return including compounding effects.

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 common compounding frequencies?
A: Annual (1), Semi-annual (2), Quarterly (4), Monthly (12), Weekly (52), Daily (365).

Q4: When is effective rate most important?
A: When comparing financial products with the same nominal rate but different compounding frequencies.

Q5: Can effective rate be lower than nominal rate?
A: No, effective rate is always equal to or greater than nominal rate due to compounding effects.