For example, in the opening scenario of this section your mortgage rates were all quoted semi-annually except for one monthly rate. An alternative is to take the “oddball” rate and convert it to match the compounding of all the other rates. This brings up the concept of equivalent interest rates, which are interest rates with different compounding that produce the same effective rate and therefore are equal to each other. Going back to the previously mentioned shortages of the nominal interest rate, if we take into account the effect of compounding interest, we obtain the Effective Annual Rate (EAR or EFF%). The concept of EAR is the same as that for the Annual Percentage Yield (APY), however, the latter form is applied mainly on investments or savings account.

## Financial Accounting

EAR can be used to evaluate interest payable on a loan or any debt or to assess earnings from an investment, such as a guaranteed investment certificate (GIC) or savings account. The change in account balance from the start at $10,000, to the end where the balance is $11,268.25, equals an effective interest https://www.quick-bookkeeping.net/ rate (12.6825%). When compounding is taken into consideration, the EAR will always be higher than the stated annual interest rate. The effective rate takes this into consideration and expresses it as a rate that is generally slightly higher than the stated interest rate but lower than the APR.

- An important concept is compounding interest, which means that interest incurred over a specific interval is added to the principal amount.
- Banks tend to advertise nominal interest rates, which are the stated interest rate, instead of the effective annual interest rate.
- Note that continuous compounding rarely occurs on loans or other financial instruments.

## How to calculate the effective interest rate

The effective interest rate is the true annually compounded interest rate that is equivalent to an interest rate compounded at some other (non-annual) frequency. To calculate the effective interest rate, you must convert the compounding on the nominal https://www.quick-bookkeeping.net/invoices/ interest rate into an annual compound. For both investment opportunities, the bank advertised the nominal interest rate. You now have to calculate the effective annual interest rate by adjusting the nominal rate for the number of compounding periods.

## How the Effective Interest Rate Works

EAR quotes are often unsuitable for short-term investments because there are fewer compounding periods. More often, EAR is used for long-term investments as the impact of compounding may be significant. This approach may limit the vehicles in which EAR is calculated or communicated. If the investor does not agree that the market interest rate matches the stated interest rate to be paid by the borrower, comment: the importance of accounting comparability the investor can bid less or more than the face amount to acquire the debt. Thus, if the market interest rate is higher than the face amount of the debt instrument, the borrower pays less for the debt, thereby creating a higher effective yield. Conversely if the market interest rate is lower than the face amount of the debt instrument, the borrower is willing to pay more for the debt.

## How do I calculate the effective interest rate?

A nominal interest rate does not consider any fees or compounding of interest. Though broadly used across the financial sector, EAR has several downsides. The EAR calculation assumes that the interest rate will be constant throughout the entire period (i.e., the full year) and that there are no fluctuations in rates. However, in reality, interest rates can change frequently and rapidly, often impacting the overall rate of return. Most EAR calculations also do not consider the impact of transaction, service, or account maintenance fees.

When banks are charging interest, the stated interest rate is used instead of the effective annual interest rate. This is done to make consumers believe that they are paying a lower interest rate. The Effective Annual Interest Rate (EAR) is the interest rate that is adjusted for compounding over a given period.

Since the compounding period may vary in different types of financial instruments, one of the main advantages of the Effective Annual Rate is that the financial products became comparable. Revisiting the opening scenario, comparing the interest rates of 6.6% compounded semi-annually and 6.57% compounded quarterly requires you to express both rates in what are pre tax payroll deductions and benefits the same units. Therefore, you could convert both nominal interest rates to effective rates. The primary difference between an effective annual interest rate and a nominal interest rate is the compounding periods. The nominal interest rate is the stated interest rate that does not take into account the effects of compounding interest (or inflation).