How to calculate effective interest rate

The effective interest rate is an interest rate which also includes the interest on the compounded amount of interest rather than the actual interest rate.

Let me simplify it for you. If you took a loan at a stated interest rate of 6% for one year and this 6% is compounded to the loan amount monthly then there is a gain of 0.005 every month as 6% / 12 = 0.005. This gain in interest rate is termed an effective interest rate. This can make an increase of 0.0617 to the initial capital making it 1.0617 as it is estimated as

(1+0.005)12 = 1.0617

On this page, we have a detailed description, calculation, formulation and example of effective interest rate

Effective interest rate calculation.

Effective period interest rate calculation

The effective period interest rate is equal to the nominal annual interest rate divided by the number of periods per year n:

Effective Period Rate = Nominal Annual Rate / n

Example

What is the effective period interest rate for nominal annual interest rate of 5% compounded monthly?

Solution:

Effective Period Rate = 5% / 12months = 0.05 / 12 = 0.4167%

Effective annual interest rate calculation

The effective annual interest rate is equal to 1 plus the nominal interest rate in percent divided by the number of compounding persiods per year n, to the power of n, minus 1.

Effective Rate = (1 + Nominal Rate / n)n - 1

Example

What is the effective annual interest rate for nominal annual interest rate of 5% compounded monthly?

Solution:

Effective Rate = (1 + 5% / 12)12 - 1

= (1 + 0.05 / 12)12 - 1

= 0.05116 = 5.116%

What is the purpose of effective interest rate?

Compelling loan fee is a pivotal term in finance as it assists with contrasting differing monetary items that work out interest on an accumulating premise. These monetary items can be lines of credits, advances or speculation instruments, for example, store certificates.16-Apr-2022