1. What is Effective Interest Rate?

The effective interest rate (also called the equivalent annual rate) is the actual interest rate that is earned or paid on an investment, loan or other financial product due to compounding over a given period of time.

2. How Does the Calculator Work?

The calculator uses the effective interest rate formula:

Where:

• \( i \) — Nominal interest rate (in decimal form)
• \( n \) — Number of compounding periods per year

Explanation: The formula accounts for the effect of compounding interest, showing the true annual cost or return of a financial product.

3. Importance of Effective Rate Calculation

Details: Comparing financial products requires understanding their true costs/returns, which the effective rate provides by incorporating compounding effects that the nominal rate doesn't show.

4. Using the Calculator

Tips: Enter nominal interest rate as a decimal (e.g., 0.05 for 5%), and the number of compounding periods per year (e.g., 12 for monthly compounding).

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 does, showing the true annual cost or return.

Q2: How does compounding frequency affect the effective rate?
A: More frequent compounding leads to higher effective rates for the same nominal rate.

Q3: When should I use the effective rate?
A: Always use it when comparing financial products with different compounding periods.

Q4: What's the effective rate for continuous compounding?
A: It's calculated as e^i - 1, where e is Euler's number (~2.71828).

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