effective interest rate

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Effective Interest Rate

The annual rate at which an investment grows in value when interest is credited more often than once a year.

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 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 interest rate

the INTEREST RATE payable on the purchase price of a BOND. For example, a bond with a face value of £100 and a NOMINAL (COUPON) INTEREST RATE of 5% generates a nominal return of £5 per year. If, however, the bond can be purchased for £50 on the open market, then the effective interest rate now rises to 10%, representing a 10% return on the £50 invested. The lower the purchase price of a bond with a given nominal rate of interest, the higher its effective rate of interest will be, and vice-versa. There is thus an inverse relationship between the price paid for a bond and its effective rate of interest (sometimes called the interest YIELD).

effective interest rate

The actual interest rate of a loan,regardless of the face interest rate or the rate quoted.See annual percentage rate.

References in periodicals archive ?
The depreciation of the asset will be recorded separately from interest expense using the effective interest method on the lease liability.
With respect to recognition and measurement, there are differences in the calculation of effective interest and treatment of variations under both the standards; however, both sets of standards generally mandate the use of the effective interest method to amortize loans and recognize interest income.
As depicted in Exhibit 3, the effective interest method is not used under U.S.
An alternative amortization method is known as the effective interest method, which is based on the effective interest rate for the bond.
Exhibit 1 illustrates the amortization table, using the effective interest method, for City Bank.
Under the effective interest method, interest is calculated and accrued each period by multiplying the discount rate that was used to measure the initial lease liability times the book value of the liability at the beginning of the period (see Table 2).
The lease liability is amortized in accordance with the effective interest method shown in the amortization schedule in Table 2.
Such fees are deferred and amortized as an adjustment to interest expense (along with any existing unamortized premium or discount) over the remaining term of the modified instrument using the effective interest method (ASC 470-50-40-17).
If the original and new debt instruments are determined to be substantially different, the fees are deemed to be associated with the new debt instrument and are amortized over its term, using the effective interest method (similar to debt issue costs); however, if the exchange or modification is not accounted for as a debt extinguishment, the fees are expensed as incurred (ASC 470-50-40-18).
While the APB expressed a clear preference for the effective interest method, the practitioner may use other methods if the results obtained are not materially different from those which would result from the interest method.
For the example shown, the difference between straight-line amortization ($3,666.67) and the amount of first-year amortization using the effective interest method ($1,845.45) is $1,821.22.
The two most prominent methods of amortization, straight line and effective interest methods, yield different results when applied to the income statement.

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