1. What is Effective Interest Rate?

The effective interest rate (also called the equivalent annual rate) is the actual interest rate that is earned or paid on an investment, loan or other financial product due to the result of compounding over a given time period.

2. How Does the Calculator Work?

The calculator uses the effective interest rate formula:

Where:

• \( r_{effective} \) — Effective annual interest rate (unitless)
• \( r_{nominal} \) — Nominal annual interest rate (unitless)
• 12 — Number of compounding periods per year

Explanation: The formula accounts for the effect of monthly compounding on the nominal interest rate.

3. Importance of Effective Rate Calculation

Details: Understanding the effective interest rate is crucial for comparing different financial products with different compounding periods, as it shows the true cost or return of a financial product.

4. Using the Calculator

Tips: Enter the nominal annual interest rate in percentage (%). The calculator will show the effective annual rate accounting for monthly compounding.

5. Frequently Asked Questions (FAQ)

Q1: What's the difference between nominal and effective interest rate?
A: The nominal rate doesn't account for compounding, while the effective rate does, showing the actual annual rate.

Q2: How does more frequent compounding affect the effective rate?
A: More frequent compounding (e.g., daily vs monthly) results in a higher effective rate for the same nominal rate.

Q3: What if the compounding is not monthly?
A: The formula changes based on compounding frequency. For daily compounding, replace 12 with 365.

Q4: Can this calculator be used for loans and investments?
A: Yes, it works for both loans (showing true cost) and investments (showing true return).

Q5: Why is the effective rate important for financial decisions?
A: It allows accurate comparison between products with different compounding frequencies.