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Effective Rate Formula:
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The effective rate (also known as annual effective yield or effective annual rate) represents the actual annual interest rate earned or paid when compounding is taken into account. It shows the true cost of borrowing or the true return on investment.
The calculator uses the effective rate formula:
Where:
Explanation: The formula accounts for the effect of compounding by calculating how many times the interest is applied to the principal amount throughout the year.
Details: Understanding the effective rate is crucial for comparing different financial products, making informed investment decisions, and accurately assessing the true cost of loans or credit cards.
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, 4 for quarterly, 365 for daily).
Q1: What's the difference between nominal and effective rate?
A: Nominal rate is the stated annual rate without compounding, while effective rate includes the effect of compounding throughout the year.
Q2: When is effective rate higher than nominal rate?
A: Effective rate is always equal to or higher than nominal rate. The difference increases with more frequent compounding.
Q3: How does compounding frequency affect effective rate?
A: More frequent compounding (daily vs. monthly vs. annually) results in a higher effective rate for the same nominal rate.
Q4: Can effective rate be used for comparing loans?
A: Yes, effective rate is the best metric for comparing different loan or investment options with varying compounding frequencies.
Q5: What is continuous compounding?
A: Continuous compounding uses the formula \( e^r - 1 \) and represents the theoretical maximum effective rate for a given nominal rate.