EFFECTIVE RATE

Effective Rate

The effective rate is the actual rate that you earn on an investment or pay on a loan after the effects of compounding frequency are considered. To make a fair comparison between two interest rates when different compounding periods are used, you should first convert both nominal (or stated) rates to their equivalent effective rates so the effects of compounding can be clearly seen.

The effective rate of an investment will always be higher than the nominal or stated interest rate when interest is compounded more than once per year. As the number of compounding periods increases, the difference between the nominal and effective rates will also increase.

To convert a nominal rate to an equivalent effective rate:

Effective Rate = (1 + (i / n))n - 1

Where:
i = Nominal or stated interest rate
n = Number of compounding periods per year

Example: What effective rate will a stated annual rate of 6% yield when compounded semiannually?

Effective Rate = ( 1 + .06 / 2 )² - 1 = .0609