Effective Rate

Effective rate

A measure of the time value of money that fully reflects the effects of compounding.

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Effective 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 annual effective 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 annual effective rate is calculated thus:

Annual effective 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 effective interest rate. See also: Stated annual interest rate, annual percentage yield.

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Effective Rate

The interest rate adjusted for intra-year compounding.

Because interest on a mortgage is calculated monthly, a 6% mortgage actually has a rate of .5% per month. If there were no principal repayments the first year, $100 invested in a 6% mortgage would actually earn $6.17 of interest during the year because of reinvestment of monthly interest. The “effective rate” is thus 6.17%, while 6% is termed the “nominal” rate. Similarly, a 6% bond on which interest is paid quarterly has an effective rate of 6.14%.