The effective interest rate, effective annual interest rate, annual equivalent r ate (AER) or simply effective rate

is the interest rate on a loan or financial p roduct restated from the nominal interest rate as an interest rate with annual c ompound interest payable in arrears.[1] It is used to compare the annual interest between loans with different compoundi ng terms (daily, monthly, annually, or other). The effective interest rate diffe rs in two important respects from the annual percentage rate (APR):[2] 1. the effective interest rate generally does not incorporate one-time char ges such as front-end fees; 2. the effective interest rate is (generally) not defined by legal or regul atory authorities (as APR is in many jurisdictions).[3] By contrast, the effective APR is used as a legal term, where front-fees and oth er costs can be included, as defined by local law.[2][3] Annual percentage yield or effective annual yield is the analogous concept used for savings or investment products, such as a certificate of deposit. Since any loan is an investment product for the lender, the terms may be used to apply to the same transaction, depending on the point of view. Effective annual interest or yield may be calculated or applied differently depe nding on the circumstances, and the definition should be studied carefully. For example, a bank may refer to the yield on a loan portfolio after expected losses as its effective yield and include income from other fees, meaning that the int erest paid by each borrower may differ substantially from the bank's effective y ield. The effective interest rate is calculated as if compounded annually. The effecti ve rate is calculated in the following way, where r is the effective annual rate , i the nominal rate, and n the number of compounding periods per year (for exam ple, 12 for monthly compounding): For example, a nominal interest rate of 6% compounded monthly is equivalent to a n effective interest rate of 6.17%. 6% compounded monthly is credited as 6%/12 = 0.005 every month. After one year, the initial capital is increased by the fact or (1 + 0.005)12 1.0617. When the frequency of compounding is increased up to infinity the calculation wi ll be: The yield depends on the frequency of compounding: Effective Annual Rate Based on Frequency of Compounding Nominal Rate Semi-Annual Quarterly Monthly Daily Continuous 1% 1.002% 1.004% 1.005% 1.005% 1.005% 5% 5.062% 5.095% 5.116% 5.127% 5.127% 10% 10.250% 10.381% 10.471% 10.516% 10.517% 15% 15.563% 15.865% 16.075% 16.180% 16.183% 20% 21.000% 21.551% 21.939% 22.134% 22.140% 30% 32.250% 33.547% 34.489% 34.969% 34.986% 40% 44.000% 46.410% 48.213% 49.150% 49.182% 50% 56.250% 60.181% 63.209% 64.816% 64.872% The effective interest rate is a special case of the internal rate of return. If the monthly interest rate j is known and remains constant throughout the year , the effective annual rate can be calculated as follows: Before you take out a bank loan, you need to know how your interest rate is calc ulated. There are many methods banks use to calculate interest rates and each me thod will change the amount of interest you pay. If you know how to calculate in terest rates, you will better understand your loan contract with your bank. You are also in a better position to negotiate your interest rate with your bank. Ba nks will quote you the effective rate of interest. The effective rate of interes t is also known as the annual percentage rate (APR). The APR or effective rate o f interest is different than the stated rate of interest. Banks also tie your in terest rate to a benchmark, usually the prime rate of interest. Effective Interest Rate on a one Year Loan

If you borrow $1000 from a bank for one year and have to pay $60 in interest for that year, your stated interest rate is 6%. Here is the calculation: Effective Rate on a Simple Interest Loan = Interest/Principal = $60/$1000 = 6% Your annual percentage rate or APR is the same as the stated rate in this exampl e because there is no compound interest to consider. This is a simple interest l oan. Effective Interest Rate on a Loan With a Term of Less Than one Year If you borrow $1000 from a bank for 120 days and the interest rate is 6%, what i s the effective interest rate? Effective rate = Interest/Principal X Days in the Year (360)/Days Loan is Outsta nding Effective rate on a Loan with a Term of Less Than one Year=$60/$1000 X 360/120 = 18% The effective rate of interest is 18% since you only have use of the funds for 1 20 days instead of 360 days. Effective Interest Rate on a Discounted Loan Some banks offer discounted loans. Discounted loans are loans that have the inte rest payment subtracted from the principal before the loan is disbursed. Effective rate on a discounted loan = Interest/Principal - Interest X Days in th e Year (360)/Days Loan is Outstanding Effective rate on a discounted loan=$60/$1,000 - $60 X 360/360 = 6.38% As you can see, the effective rate of interest is higher on a discounted loan th an on a simple interest loan. Effective Interest Rate with Compensating Balances Some banks require that the small business firm applying for a business bank loa n hold a balance, called a compensating balance, with their bank before they wil l approve a loan. This requirement makes the effective rate of interest higher. Effective rate with compensating balances (c) = Interest/(1-c) Effective rate compensating balance= 6%/(1 - 0.2) = 7.5% (if c is a 20% compensa ting balance) Effective Interest Rate on Installment Loans One of the most confusing interest rates that you will hear quoted on a bank loa n is that on an installment loan. Installment loan interest rates are generally the highest interest rates you will encounter. Using the example from above: Effective rate on installment loan = 2 X Annual # of payments X Interest/(Total no. of payments + 1) X Principal Effective rate/installment loan=2 X 12 X $60/13 X $1,000 = 11.08% The interest rate on this installment loan is 11.08% as compared to 7.5% on the loan with compensating balances. 4. Effective annual interest rate on installment loans An installment (amortized) loan is a loan that is periodically paid off in equal installments. Examples may include car loans, commercial loans, and mortgages. There are four methods used to calculate the effective annual interest rate on i nstallment loans (refer to the table below). Illustration 2: Effective interest rates on installment loans Actuarial method Most accurate method Used by lenders Complicated formulas Constant-ratio method Simple formula Overstated EAR Higher quoted rate, more overstated EAR EAR = 2 x M x C [P x (N + 1)] M is the number of payment periods per year C is the cost of credit (finance charges) P is the original proceeds N is the number of scheduled payments Direct-ratio method Simple formula More complicated than constant-ratio method but less complicated than actuarial

method Slightly understates effective annual interest rate EAR = 6 x M x C [3 x P x (N+1) + C x (N+1)] M is the number of payment periods per year C is the cost of credit (finance charges) P is the original proceeds N is the number of scheduled payments N-ratio method More accurate than constant-ratio or direct-ratio methods Effective annual interest rate is slightly overstated or understated depending o n the nominal rate and the maturity of the loan EAR = M x C x (95 x N + 9) [12 x N x (N+1) x (4P+C)] M is the number of payment periods per year C is the cost of credit (finance charges) P is the original proceeds N is the number of scheduled payments If the amount of payment or time between payments varies from period to period ( e.g., balloon payments), the constant-ratio, direct-ratio, and N-ratio methods c annot be used. If a lender charges a credit investigation, loan application, or life insurance fee, such a cost should be added to the cost of credit (finance c harge). Let us look at a simple example to see how the effective annual interest rate is calculated on installment loans. Installment Loans Example 1: Company ABC borrows $12,000 to be repaid in 12 months. The monthly installments are $1,116 each. The finance charge is $1,400. What is the approximate value of effective annual interest rate? Constant ratio method: EAR = 2 x 12 x $1,400 = 0.2154 12,000 x (12+1) Direct-ratio method: EAR = 6 x 12 x $1,400 = 0.2073 3 x 12,000 x (12 + 1) +1,400 x (12+1) N-ratio method: EAR = 12 x $1,400 (95 x 12 + 9) = 0.2104 12 x 12 (12 + 1)(4 x 12,000 + 1,400) Using the actuarial method, the effective annual interest rate is likely to be c lose to 21.04%. As we can see from this example, the constant-ratio method overstated the effect ive annual interest rate, while the direct-ratio method slightly understated the effective annual interest rate on the installment loan. There is another method used to approximate this rate on one-year installment lo ans to be paid in equal monthly installments. The effective interest rate is det ermined by dividing the interest by the average amount outstanding for the year. If the loan is discounted, the average loan balance equals the average of proce eds (i.e., principal less interest). Installment Loans Example 2: Company ABC borrows $10,000 at a 10% interest rate to be paid in 12 monthly inst allments. In this example, the EAR could be approximated as follows: Interest = $12,000 x 0.10 = $1,200 Average Loan Balance = $12,000 2 = $6,000 Effective Annual Interest Rate = $1,200 $6,000 = 0.20 If this loan is discounted, the effective annual interest rate will be calculate d as follows: Interest = $1,200 Proceeds = $12,000 - $1,200 = 10,800 Average Loan Balance: $10,800 2 = $5,400

Effective Annual Interest Rate = $1,200 $5,400 = 0.2222