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Effective Annual Interest Rate |
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Effective annual interest rate An annual measure of the time value of money that fully reflects the effects of compounding. Effective Interest Rate The interest rate on a debt or debt security that takes into account the effects of compounding. For example, if one has a fixed-income investment such as certificate of deposit that pays 3% in interest each month, the effective interest rate is more than 3% because compounding the interest results in a (slightly) greater principal each month on which the interest rate is calculated. In this example, the effective interest rate rate is calculated thus: Effective interest rate = (1 + .03/12)^12 - 1 = .0304 = 3.04%, where .03 is the simple interest rate and 12 is the number of times in a year interest is compounded. It is also known as the annual effective rate or the annual equivalent rate. See also: Stated annual interest rate, annual percentage yield. Effective Annual Interest Rate ![]() What Does Effective Annual Interest Rate Mean? The annual rate of interest of an investment when compounding occurs more often than once a year. It is calculated as follows: Investopedia explains Effective Annual Interest Rate Consider a stated annual rate of 10%. Compounded yearly, this rate will turn $1,000 into $1,100. However, if compounding occurs monthly, $1,000 will grow to $1,104.70 by the end of the year, for an effective annual interest rate of 10.47%. Basically, the effective annual rate is the annual rate of interest that accounts for compounding. Related Terms: Want to thank TFD for its existence? Tell a friend about us, add a link to this page, add the site to iGoogle, or visit the webmaster's page for free fun content. |
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