Effective rate of return definition
/What is the Effective Rate of Return?
The effective rate of return is the rate of return generated by an investment when all factors impacting receipts are considered. These factors include the price at which the instrument was purchased, the stated interest rate to be paid by the issuer of the instrument, and any compounding used in the calculation of interest paid. This approach generates the most comprehensive view of the return on an investment. It is more accurate than the stated or nominal rate of return, which does not incorporate the impact of compounding.
A more limited definition of the effective rate of return is to only focus on the impact of compounding, rather than to also include the price at which an investment instrument was purchased (which can vary from its face value).
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Factors Impacting the Effective Rate of Return
The effective rate of return is impacted by the price paid. An investor may purchase an investment instrument at less than its stated price, in which case the effective rate of return increases. Conversely, the investor may be willing to purchase an investment instrument at more than its stated price, in which case the effective rate of return decreases. For example, a 6% bond purchased for $980 has a higher effective rate of return than a 6% bond purchased for $1,020, even though both bonds have a face value of $1,000.
In addition, the effective rate of return is indirectly impacted by the stated interest rate. The impact is seen only when the price paid or the effects of compounding are considered.
Finally, the effective rate of return is impacted by compounding. The terms of an investment instrument may state that there is no compounding of interest, in which case the stated interest rate is the actual rate of interest paid. However, if compounding is allowed, such as on a monthly or quarterly basis, then the effective interest rate increases. For example, if the 6% stated interest rate on a $1,000 investment compounds monthly, then the effective rate of return for the first month is at an annualized rate of 6%, but the annualized amount for the second month is 6.03%, since the interest earned in the first month is added to the principal balance of the investment for interest calculation purposes.
Calculating the Effective Rate of Return with Excel
Excel has an effective rate calculator. To derive the effective interest rate, simply include the nominal interest rate and the number of compounding periods in the EFFECT function, using the following layout:
=EFFECT (effective interest rate, number of compounding periods)
For example, the entry =EFFECT(7.5%,12) returns a value of 7.76%.
When using the EFFECT function, be sure to set the number of compounding periods properly. For example, if compounding occurs daily, then the entry is 365, while it is 52 if compounding occurs weekly, and 12 if compounding is calculated monthly.