Let us take the example of an investment with the stated rate

of interest of 10%. Calculate the effective interest rate if the

investment is to be compounded twice a year.

Stated Rate of Interest (i) 10%

Number of Compounding Periods
4
Per Year (n)

Effective Interest Rate is calculated using the formula given below

Effective Interest Rate = (1 + i/n)n – 1

Effective Interest Rate 10.38%

 Beginning
Interest Principal Ending Balance
Balance

1 $501,000.00 $4,960.72 $14,424.20 $486,575.80

2 $486,575.80 $4,817.90 $14,567.02 $472,008.78

3 $472,008.78 $4,673.66 $14,711.26 $457,297.52

4 $457,297.52 $4,527.99 $14,856.93 $442,440.59

5 $442,440.59 $4,380.88 $15,004.03 $427,436.56

6 $427,436.56 $4,232.32 $15,152.60 $412,283.96

7 $412,283.96 $4,082.28 $15,302.63 $396,981.32

8 $396,981.32 $3,930.76 $15,454.15 $381,527.17

9 $381,527.17 $3,777.74 $15,607.18 $365,919.99

10 $365,919.99 $3,623.21 $15,761.71 $350,158.28

11 $350,158.28 $3,467.14 $15,917.78 $334,240.50

12 $334,240.50 $3,309.53 $16,075.39 $318,165.11

Year #1 End

13 $318,165.11 $3,150.35 $16,234.56 $301,930.54

14 $301,930.54 $2,989.61 $16,395.31 $285,535.23

15 $285,535.23 $2,827.27 $16,557.65 $268,977.58

16 $268,977.58 $2,663.32 $16,721.60 $252,255.98

17 $252,255.98 $2,497.75 $16,887.17 $235,368.80

18 $235,368.80 $2,330.54 $17,054.38 $218,314.42

19 $218,314.42 $2,161.67 $17,223.25 $201,091.17

20 $201,091.17 $1,991.13 $17,393.79 $183,697.39

21 $183,697.39 $1,818.90 $17,566.01 $166,131.37

22 $166,131.37 $1,644.97 $17,739.95 $148,391.42

23 $148,391.42 $1,469.32 $17,915.60 $130,475.82

24 $130,475.82 $1,291.92 $18,092.99 $112,382.83

Year #2 End

25 $112,382.83 $1,112.77 $18,272.15 $94,110.68

26 $94,110.68 $931.85 $18,453.07 $75,657.61

27 $75,657.61 $749.13 $18,635.78 $57,021.83

28 $57,021.83 $564.61 $18,820.31 $38,201.52

29 $38,201.52 $378.26 $19,006.66 $19,194.86

30 $19,194.86 $190.06 $19,194.86 $0.00

John who is interested in investing a bond that offers a stated rate of interest of 9%.
However, the nature of compounding is different and John is not sure which
compounding will yield the highest return. Calculate the effective interest
rate and help John take a fruitful decision for the compounding period:

Stated Rate of Interest (i) 9%

For Annual

Number of Compounding
1
Periods Per Year (n)

Effective Interest Rate is calculated using the formula given below

Effective Interest Rate = (1 + i/n)n – 1

Effective Interest Rate 9%

For Half-Yearly

Number of Compounding
2
Periods Per Year (n)

Effective Interest Rate is calculated using the formula given below

Effective Interest Rate = (1 + i/n)n – 1

Effective Interest Rate 9.20%

For Quarterly

Number of Compounding
4
Periods Per Year (n)

Effective Interest Rate is calculated using the formula given below

Effective Interest Rate = (1 + i/n)n – 1

Effective Interest Rate 9.31%

For Monthly

Number of Compounding
12
Periods Per Year (n)

Effective Interest Rate is calculated using the formula given below

Effective Interest Rate = (1 + i/n)n – 1

Effective Interest Rate 9.38%

For Daily

Number of Compounding
365
Periods Per Year (n)

Effective Interest Rate is calculated using the formula given below

Effective Interest Rate = (1 + i/n)n – 1

Effective Interest Rate 9.42%