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Ofterms - Human-edited, online financial dictionary terms

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Ofterms provides simple financial information.

Effective interest rate

An effective interest rate is the annual rate of interest on an investment, loan, or other financial item, when compounding occurs more than once per year. It is also commonly known as the effective annual interest rate, or the annual equivalent rate.

For example, say an investment of $1000 had a stated annual interest rate of 5%. Nominally, it would be expected to be worth $1050 after a year. However, if the compounding occurs monthly, then the actual worth after a year would be roughly $1051.20, meaning that the effective interest rate would be around 5.12%.

The actual rate depends upon factors such as the nominal rate and the frequency with which the compounding occurs. For instance: compounding may take place semi-annually, quarterly, monthly, daily or "continuously." The more frequently the compounding occurs, the higher the effective interest rate will be.

The effective interest rate varies from the annual percentage rate (APR), in that it does not include one-off charges, and is normally not legally defined. On the other hand, annual percentage yield (APY) is a similar calculation to effective interest rate, and is used in savings and investments.


Synonyms, related terms and other keywords:

• Annual percentage rate (APR)
• Annual percentage yield (APY)
• Internal rate of return (IRR)