How to Calculate Effective Annual Interest Rate - Formula, Example

Definition:

Effective Annual Rate is used to find out the actual annual rate that would be paid on a loan if the specified annual rate is affected by compounding.

Example :

Annual interest rate of a firm is 10% compounded monthly payments, then what is the effective interest rate of the firm?

Given,

Nominal Annual Interest Rate (r) = 10% = 0.1 Number of payments per year (n) = 12

To Find,

Effective Interest Rate

Solution :

Effective Interest Rate (i) = [1 + (r/n)]ⁿ - 1 = [1 + (0.1/12)]¹² - 1 = [1 + 0.008333]¹² - 1 = 1.104713063 - 1 = 0.104713063 x 100 = 10.4713 %

Result :

Effective Annual Interest Rate is 10.4713 %