Effective Rate Of Interest

effective rate of interest

The rate of interest that incorporates compounding in the calculation used to determine the amount of interest to be credited to an account. For amounts invested during an entire year, the annual effective rate of interest multiplied by the principal will equal the amount of earned interest.

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Effective Rate Of Interest

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 of interest is more than 3% because compounding the interest adds results in a (slightly) greater principal each month on which the interest rate is calculated. In this example the annual effective rate of interest is calculated thus:

Effective rate of interest = (1 + .03/12)^12 - 1 = .0304 = 3.04%, where .03 is simple interest rate and 12 is the number of times in a year interest is compounded. It is also known as the effective rate. See also: Stated annual interest rate, annual percentage yield.