Effective Interest Rate Calculator
The formula for Effective Interest Rate is the following:
r = (1 + i/n)n-1
r = Effective Annual Rate
i = Nominal Rate
**Note: Nominal Interest Rate is the stated Intesest rate for the investment product.
n = Number of Compounding Periods per Year
Firms evaluate the Effective Interest Rate to anaylze the difference between financial products. The difference between the stated rate of two different investments can have a significant impact over a long-term investment, and the difference isn't always apparent. The difference is a result of how the interest is compounded.
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 based on simple interest at 7%, he would make $1070 after a year. 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.