The effective rate of return is the rate of return generated by an investment when all factors impacting receipts are considered. This approach generates the most comprehensive view of the return on an investment. These factors include:
- The price at which the instrument was purchased
- The stated interest rate to be paid by the issuer of the instrument
- Any compounding used in the calculation of interest paid
The effective rate of return is impacted by each of these factors in the following ways:
- Price paid. The 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.
- Stated interest rate. The stated interest rate on an investment does not directly impact the effective rate of return; instead, it impacts the effective rate only when the price paid or the effects of compounding are considered.
- 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.
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).