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
Two essential principles to be aware of when comparing the returns on financial instruments are:
- More frequent compounding results in a higher effective interest rate
- A larger discount from the face amount of an investment results in a higher effective interest rate