1. What is Effective Interest Rate?

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

2. How Does the Calculator Work?

The calculator uses the effective interest rate formula:

Where:

• \( i \) — Nominal interest rate (in decimal form)
• \( n \) — Number of compounding periods per year

Explanation: The formula accounts for the effect of compounding, showing the true annual rate when interest is compounded multiple times per year.

3. Importance of Effective Rate Calculation

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

4. Using the Calculator

Tips: Enter the nominal interest rate as a decimal (e.g., 5% = 0.05) and the number of compounding periods per year (e.g., monthly = 12, quarterly = 4).

5. Frequently Asked Questions (FAQ)

Q1: What's the difference between nominal and effective rate?
A: Nominal rate doesn't account for compounding, while effective rate does. The effective rate will always be equal to or higher than the nominal rate.

Q2: How does compounding frequency affect the effective rate?
A: More frequent compounding results in a higher effective rate. Daily compounding gives a higher rate than monthly, which is higher than annual.

Q3: What is continuous compounding?
A: When compounding occurs infinitely often, the formula becomes \( e^{i} - 1 \) where e is Euler's number (~2.71828).

Q4: Can the effective rate be lower than the nominal rate?
A: No, the effective rate can never be lower than the nominal rate when dealing with positive interest rates.

Q5: How is this used in financial decisions?
A: It helps compare loans or investments with different compounding periods to find the best option.