What is the Effective Interest Rate?

The effective interest rate is that rate of interest actually earned on an investment or loan over the course of a year, incorporating the effects of compounding. Thus, an investment that has a stated (nominal) interest rate of 5% may actually have a higher effective interest rate, once the impact of compounding is added to the calculation of interest.

The concept is useful for measuring the return on financial instruments that have different terms. For example, the effective interest rate can be used to compare the return on a loan that compounds monthly to one that compounds quarterly, or to compare the return on a bond that was acquired at a discount from its face amount to one that was acquired at a premium. The effective interest rate calculation is:

(1 + (nominal rate / number of compounding periods)) ^ (number of compounding periods) - 1

= Effective interest rate

There are several principles to be aware of when comparing the return on financial instruments, which are as follows:

Compounding frequency. More frequent compounding results in a higher effective interest rate.
Discount size. A larger discount from the face amount of an investment results in a higher effective interest rate.

Characteristics of the Effective Interest Rate

The key characteristics of the effective interest rate are as follows:

Includes compounding effects. Unlike the nominal interest rate, the effective interest rate accounts for the impact of compounding within a year.
Depends on compounding frequency. The more frequently interest is compounded, the higher the effective interest rate.
Higher than the nominal interest rate. When interest is compounded more frequently (e.g., monthly or quarterly), the effective interest rate will always be higher than the nominal interest rate.
Expressed as an annual rate. The effective interest rate is typically presented on an annual basis, even if interest is compounded more frequently.