EFFECTIVE RATE

INTEREST
Members:
Jeanne Marie Fronda
Jethro Galivo
Jerick Campos
 Effective Interest Rate
It is the real return on a savings account or any
interest-paying investment when the effects of
compounding overtime are taken into account. It
reveals the real percentage rate owed in interest
on a loan, a credit card, or any other debt.
 It is also called effective rate or the annual
equivalent rate
 The more frequent the compounding periods,
the greater the return
Importance of Effective Rate Interest
 The Effective Annual Interest Rate is important because, without
it, borrowers might be misled into underestimating the true cost
of a loan. This in turn could lead to financial problems if the
borrower failed to budget for the full amount of their interest
payments.
 For investors, on the other hand, calculating the Effective Annual
Interest Rate is important to project the actual expected return
on an investment, such as a corporate bond or another fixed-
income security. Failing to do so could cause them to
underestimate the actual attractiveness of an investment
opportunity.
 What is the relationship between effective rate of interest and
compounding interest?
 Compounding is a powerful application of interest calculation.
When compounding is used, stated interest rate will result in an
effective rate that is not the same as the nominal rate. Note that
when we talk about a stated interest we mean the annual rate
example 10% annual rate of return investment. When we talk
about the effective annual interest rate, we mean the actual rate
resulting from the interest compounding example 10.25%annual
rate of return on the same investment.
• The effective rate differs from the nominal
interest rate when compounding occurs more
than once a year and it depends on the
frequency of compounding
Steps required to calculate the effective interest rate:
Locate in the loan documents the compounding
period. It is likely to be either monthly, daily,
quarterly, semi-annually or annually.
Locate the stated interest rate in the loan
documents.
Enter the compounding period and stated
interest rate into the effective interest rate formula
For example:
A loan document contains a stated
interest rate of 10% and mandates
quarterly? monthly? semi-annually? Daily?
E = (1 + i/n)n-1
Where:
E = The effective interest rate
i = The stated interest rate
n = The number of compounding periods
per year
 Given:
i= interest rate (10% or 0.1)
n= number of compounding periods per year
(Quarterly or 4 times a year)
E= (1 + i/n)n-1
E= (1+ 10% / 4) 4 -1
E= (1+ 0.1/4) 4-1
E= (1 + 0.025) 4-1
E= (1.025) 4-1
E= (1.1038128906) – 1
E= (0.1038128906)100
E= 10.38128906% or 10.38% effective rate interest
quarterly
Given:
i= interest rate (10% or 0.1)
n= number of compounding periods per year ( monthly or 12
times a year)
E= (1 + i/n)n-1
E= (1+ 10% / 12) 12 -1
E= (1+ 0.1/12) 12-1
E= (1 + 0.0083) 12-1
E= (1.008333333333) 12-1
E= (1.1047130674) – 1
E= (0.1047130674)100
E= 10.47130674% or 10.47% effective rate interest monthly
 Given:
i= interest rate (10% or 0.1)
n= number of compounding periods per year ( Daily or 365
times a year)
E= (1 + i/n)n-1
E= (1+ 10% / 365) 365 -1
E= (1+ 0.1/365) 365-1
E= (1 + 0.0002739726) 365-1
E= (1.0002739726) 365-1
E= 1.1051557805-1
E= (0.1051557805)100
E= 10.51557805 % or 10.516% effective rate interest daily
 Given:
i= interest rate (10% or 0.1)
n= number of compounding periods per year (Semi-
annually or 2 times each year )
E= (1 + i/n)n-1
E= (1+ 10% / 2) 2-1
E= (1+ 0.1/2) 2-1
E= (1 + 0.05) 2-1
E= (1.05) 2-1
E= 1.1025-1
E= (0.1025)100
E= 10.25
E= 10.25% effective rate interest semi-annually
John invest $5,000 in a term deposit scheme. The
scheme offers an interest rate of 6% per year,
compounded quarterly. How much interest will
John earn after one year? Also, what is the
effective rate of interest?
Given:
i = interest rate (6% or 0.06)
n = number of compounding periods per year
(Quarterly or 4 times a year)
P= Principal Amount ($ 5000)
E= (1 + i/n) n-1
E= (1+0.06/4)4-1
E= (1+0.015)4-1
E= (1.015)4-1
E= 1.0613635506 -1
E = 0.0613635506 (100)
E=6.13635506 or 6.14%
P= Principal Amount ($ 5000)
There are two ways we can get the total interest that
John earned after one year:
I= P (E)
I= P(1 + i/n)n-1) I= $ 5,000 (6.14%)
I = $ 5000 (1+0.06/4)4-1 I= $ 5,000 (0.0614)
I = $ 5000 (1+0.015)4-1 I= $ 307
I = $ 5000(1.015)4-1
I = $ 5000 (1.0614 -1)
I = $ 5000 (0.0614)
I= $307
Assessment
 Interest Rate

E = (1 + i/n) -1 n

Effective Rate of interest

Number of compounding period
Peter invest P10,000 for one year at the rate of 6%
per annum. The interest is compounded semi-
annually. Calculate the interest earned in the first
six months and the effective rate of interest
Given:
Principal Amount (P) = P10,000
Interest rate (i) = (6% or 0.06)
Number of compounding periods per year (n)=
Semi-annually (2 times a year)
Given:
Principal Amount (P) = P10,000
Interest rate (i) = (6% or 0.06)
Number of compounding periods per year (n)= Semi-
annually (2 times a year)

E= (1 + i/n) n -1
E= (1+0.06/2)2 -1
E= (1+0.03)2 -1
E= (1.03)2 -1
E= 1.0609 -1
E = 0.0609(100)
E= 6.09%
Given:
Principal Amount (P) = P10,000
Interest rate (i) = (6% or 0.06)
Number of compounding periods per year (n)= Semi-
annually (2 times a year)
I= P(E)
I= P(1 + i/n) -1)
n

I= P10,000(1+0.06/2)2-1 I= P10,000(6.09%)
I=P10,000 (1+0.03)2-1
I= P10,000 (1.03)2-1
I= P10,000(0.0609)
I=P10,000( 1.0609-1) I= P609
I=P10,000 (0.0609)
I= P609
Thank You!!!