Effective Interest Rate Formula (Table of Contents)
Formula
Examples
Calculator
What is the Effective Interest
Rate Formula?
The term “effective interest rate” refers to the investment’s true
annual yield that is earned due to the result of compounding over
the period of time. Conversely, the effective interest rate can be
seen as the true cost of borrowing from the point of view of a
borrower. It is also known as the effective annual return or the
annual equivalent rate. The formula for effective interest rate can be
derived on the basis of the stated rate of interest and the number of
compounding periods per year. Mathematically, it is represented as,
Effective Interest Rate = (1 + i/n)n – 1
where,
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i = Stated Rate of Interest
n = Number of Compounding Periods Per Year
Examples of Effective Interest Rate
Formula (With Excel Template)
Let’s take an example to understand the calculation of Effective
Interest Rate in a better manner.
You can download this Effective Interest Rate Formula Excel Template here – Effective
Interest Rate Formula Excel Template
Effective Interest Rate Formula– Example #1
Let us take the example of an investment with the stated
rate of interest of 10%. Calculate the effective interest rate
if the investment is to be compounded twice a year.
Solution:
Effective Interest Rate is calculated using the formula given below
Effective Interest Rate = (1 + i/n)n – 1
Effective Interest Rate = (1 + 10%/2) 2 – 1
Effective Interest Rate = 10.25%
Therefore, the effective interest rate for the quoted investment is
10.25%.
Effective Interest Rate Formula– Example #2
Let us take the example of John who is interested in
investing a bond that offers a stated rate of interest of 9%.
However, the nature of compounding is different and John is
not sure which compounding will yield the highest return.
Calculate the effective interest rate and help John take a
fruitful decision for the following compounding period:
1. Annual
2. Half-yearly
3. Quarterly
4. Monthly
5. Daily
Annual
Effective Interest Rate is calculated using the formula given below
Effective Interest Rate = (1 + i/n)n – 1
Effective Interest Rate = (1 + 9%/1) 1 – 1
Effective Interest Rate = 9%
Half-Yearly
Effective Interest Rate is calculated using the formula given below
Effective Interest Rate = (1 + i/n)n – 1
Effective Interest Rate = (1 + 9%/2) 2 – 1
Effective Interest Rate = 9.20%
Quarterly
Effective Interest Rate is calculated using the formula given below
Effective Interest Rate = (1 + i/n)n – 1
Effective Interest Rate = (1 + 9%/4) 4 – 1
Effective Interest Rate = 9.31%
Monthly
Effective Interest Rate is calculated using the formula given below
Effective Interest Rate = (1 + i/n)n – 1
Effective Interest Rate = (1 + 9%/12) 12 – 1
Effective Interest Rate = 9.38%
Daily
Effective Interest Rate is calculated using the formula given below
Effective Interest Rate = (1 + i/n)n – 1
Effective Interest Rate = (1 + 9%/365) 365 – 1
Effective Interest Rate = 9.42%
Therefore, it can be clearly seen that annual yield increases with the
increase in the number of compounding happening per year. As
such, the option of daily compounding will offer the best yield for
John (effective interest of 9.38% against the stated rate of interest
of 9%).
Explanation
The formula for the effective interest rate can be derived by using
the following steps:
Step 1: Firstly, determine the stated rate of interest of the
investment, which is usually mentioned in the investment
document. It is denoted by ‘i’.
Step 2: Next, figure out the number of compounding periods during
a year and it is denoted by “n”. Usually, the compounding is done
quarterly, half-yearly and annually which means a number of
compounding per year of 4, 2 and 1 respectively.
Step 3: Finally, the formula for effective interest rate can be
derived by using the stated rate of interest (step 1) and a number of
compounding periods per year (step 2) as shown below.
Effective Interest Rate = (1 + i/n)n – 1
Relevance and Uses of Effective
Interest Rate Formula
It is important to understand the concept of an effective interest
rate because it is a vital metric for an investor or another financial
user. The investors tend to use the effective interest rate
predominantly as it is the actual yield received from an investment.
As such, the investors lay greater emphasis on the number of
compounding per year as a higher number of compounding means
greater yield. On the other hand, the perspective changes for a
borrower who seeks a lower number of compounding per year as it
would keep their interest expense low and result in better
profitability.
The concept of effective interest rate is very dependent on the
number of compounding happening during a year that finally higher
yield or eventually higher redemption value at maturity. Typically,
the effective annual rate increases with the increase in the number
of compounding per year. Although compounding can be done an
infinite number of times, it should be kept in mind that there is a
certain limit to the compounding effect and beyond which the
phenomenon ceases to happen. That type of compounding is known
as continuous compounding for which the effective interest rate is
expressed as – ei, i is the stated rate of interest and it is
independent of the compounding period.
Effective Interest Rate Formula
Calculator
You can use the following Effective Interest Rate Formula Calculator
i 0
n 0
Effective Interest Rate 0
Effective Interest Rate =
(1 + i/n)n-1
= (1 + 0/0)0-1 = 0
Recommended Articles
This is a guide to Effective Interest Rate Formula. Here we discuss
how to calculate Effective Interest Rate along with practical
examples. We also provide an Effective Interest Rate calculator with
a downloadable excel template. You may also look at the following
articles to learn more –
1. Formula For Monthly Compound Interest
2. How to Calculate the Nominal Interest Rate?
3. Examples of Interest Expense
4. Calculation of Nominal GDP Formula
5. Interest vs Dividend | Top 8 Key Differences You Should Know
6. Guide to Annual Ret
