Effective annual Rate

Written by Fmi.Online Friday January 6, 2023
Effective annual rate is the actual return on a deposit per year after compounding.

Explanation :

  The effective annual rate is the actual return on a deposit after taking into account the number of times interest is paid over a period of a year. It is a benchmark to compare deposits taking into account the accumulative power of earning interest on interest.Banks will always offer an interest rate  over a specific period making use of a quoted rate. This is the nominal interest rate. The effective rate of return is seldom used in advertising headlines. To do a comparison of returns on these deposits a benchmark period of one year is used. The same concept applies to loans.

In a nutshell :

  • The effective annual interest rate is the true interest rate on an investment or loan because it takes into account the effects of compounding.
  • The more frequent the compounding periods, the higher the rate.
  • A savings account or a loan may be advertised with both a nominal interest rate and an effective annual interest rate.
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