The formula for Effective Interest Rate is the following:
r = (1 + i/n)n-1
r = Effective Annual Rate
i = Nominal Rate
n = Number of Compounding Periods per Year
Sample Effective Interest Rate Problem
Jayden is going to put his money in the bank that is offering 7% and it is compounded monthly, what is his effective interest rate?
His effective interest rate is 7.229%.
In looking at this, if you were to just calculate how much interest he would earn at 7%, he would make $1070. However if you consider the effect of compounding interest, he actually will make $1072.29. While this isn't significant, every dollar counts and this will add up over time.