Effective Interest Rate

Three Kinds of Rates

1. Periodic rate (i) - it is the rate used to compute

compound interest factors, and it is equal to
interest rate divided by the conversion period.

2. Nominal rate (r) - the stated annual rate of

interest when the conversion period is other than
a year.

3. Effective rate ( ieff) - the annual rate of interest

when the conversion period is one year.
 Financial Jargon
18% Compounded Monthly

Nominal Interest
interest Period
rate
 18% Compounded Monthly
What it really means?

18%
❑ Interest rate per month (i) = = 1.5%
12
❑ Number of Interest periods per year (m) = 12

Bank will charge 1.5% interest each

month on your unpaid balance if you
borrowed money.
You will earn 1.5% interest each month
on your remaining balance, if you
deposited money.
Effective Rate of Interest

𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1+ −1
𝑚
ieff = effective annual interest rate
r = nominal interest rate per year
m = no of interest periods per year
 Example:

18% compounded monthly

Effective annual interest rate? 18%

❑ (i) = = 1.5%
12

𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1 + −1
𝑚 12
0.18
𝑖𝑒𝑓𝑓 = 1 + − 1 = 19.56%
12
1.5% per month for 12 months
19.56% compounded once per year
 𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1+ −1
𝑚
𝑟 𝑚
𝑖𝑒𝑓𝑓 + 1 = 1 +
𝑚
1/𝑚 𝑟
𝑖𝑒𝑓𝑓 + 1 =1+
𝑚
1/𝑚 𝑟
𝑖𝑒𝑓𝑓 + 1 −1=
𝑚

1/𝑚
𝑟 = 𝑚 𝑖𝑒𝑓𝑓 + 1 − 1 x 100%
1. What nominal rate compounded
monthly, will yield an effective rate of
5.5%?
𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1 + −1
𝑚
𝑟 12
0.055 = 1 + −1
12
𝑟 = 5.37%
2. A credit card company charges 21% interest
per year, compounded monthly. What effective
annual interest rate does the company charge?

𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1 + −1
𝑚 12
0.21
𝑖𝑒𝑓𝑓 = 1 + −1
12
𝑖𝑒𝑓𝑓 = 23.14%
4. Berong has P100,000 to invest. Will he deposit the

amount in the bank paying 8% compounded semi-annually or

invest the money in an investment firm paying 7%

compounded quarterly?
4. Berong has P100,000 to invest. Will he deposit the

amount in the bank paying 8% compounded semi-annually or

invest the money in an investment firm paying 7%

compounded quarterly?
𝑟 𝑚𝑡
Compute for F 𝐹 =𝑃 1+
𝑚
2𝑥1
0.08
𝐹 = 𝑃100,000 1 + = 𝑃108,160.00
2
4𝑥1
0.07
𝐹 = 𝑃100,000 1 + = 𝑃107,185.90
4
4. Berong has P100,000 to invest. Will he deposit the

amount in the bank paying 8% compounded semi-annually or

invest the money in an investment firm paying 7%

compounded quarterly? 𝑚
𝑟
Compare the ieff 𝑖𝑒𝑓𝑓 = 1+ −1
2 𝑚
0.08
𝑖𝑒𝑓𝑓 = 1 + − 1 = 8.29%
2
4
0.07
𝑖𝑒𝑓𝑓 = 1 + − 1 = 7.19%
4
NOMINAL AND EFFECTIVE RATE

3. If interest is compounded quarterly, find the

nominal rate, which will yield an effective rate

of 6.5 %?
6. Should I invest in a savings and loan association

paying 7% converted quarterly or in bonds yielding 7.5%

effective?

7. XYZ savings is paying 9% interest rate compounded

semi-annually while ABC savings is paying 9.5%

effective. With whom should I invest my money?

Equivalent Rates
1. What rate compounded semi-annually is
equivalent to 6% compounded monthly?

𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1+ −1
𝑚
12 2
0.06 𝑥
1+ −1= 1+ −1
12 2
1. What rate compounded semi-annually is
equivalent to 6% compounded monthly?

𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1+ −1
𝑚
12 2
0.06 𝑥
1+ −1= 1+ −1
12 2
 𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1+ −1
𝑚
𝑚1
𝑟1 𝑟2 𝑚2
1+ −1= 1+ −1
𝑚1 𝑚2
𝑚1
𝑟1 𝒓𝟐 𝑚2
1+ = 1+
𝑚𝑚1 𝑚2
1 /𝑚2
𝑟1 𝑟2
1+ =1+
𝑚1 𝑚2
𝑚1 /𝑚2
𝑟1 𝑟2 𝑚1 /𝑚2
1+ −1= 𝑟1
𝑚1 𝑚2 𝑟2 = 𝑚2 1+ −1
𝑚1
1. What rate compounded semi-annually is
equivalent to 6% compounded monthly?

𝑟 𝑚
𝑖𝑒𝑓𝑓 = 1+ −1
𝑚
12 2
0.06 𝑥
1+ −1= 1+ −1
12 2

𝑥 = 6.08%
 If a lender charges 12% interest, compounded monthly,
what is the effective interest rate per quarter?

12 4
0.12 𝑥
1+ −1= 1+ −1
12 4
𝑚1 /𝑚2
𝑟1
𝑟2 = 𝑚2 1+ −1
𝑚1
𝑥 = 0.1212 ( 𝑟)

𝑟 0.1212
𝑖= = = 𝟑. 𝟎𝟑%
𝑚 4
1. What rate compounded semi-annually is
equivalent to 6% compounded monthly?

2. What rate converted monthly is equivalent to

9.2% compounded quarterly?

3. If you are to invest P500 000 at 14%

converted semi-annually for 7 years, what
rate compounded quarterly could you just as
well invest your money?
• To determine the simple interest rate
equivalent to compound interest rate.
Equate the Future amount

𝑟𝑐 𝑚𝑡
𝐹 =𝑃 1+
𝑚
𝐹 = 𝑃(1 + 𝑟𝑠 𝑡)
𝑟𝑐 𝑚𝑡
𝑃 1+ = 𝑃(1 + 𝑟𝑠 𝑡)
𝑚
• To determine the simple interest rate
equivalent to compound interest rate.
Equate the Future amount

𝑟𝑐 𝑚𝑡
𝐹 =𝑃 1+
𝑚
𝐹 = 𝑃(1 + 𝑟𝑠 𝑡)
𝑟𝑐 𝑚𝑡
𝑃 1+ = 𝑃(1 + 𝑟𝑠 𝑡)
𝑚
• To determine the simple interest rate
equivalent to compound interest rate
and vice versa.
Equate the Future amount 𝑚𝑡
𝑟𝑐
𝐹 =𝑃 1+
𝑚
𝐹 = 𝑃(1 + 𝑟𝑠 𝑡)
𝑟𝑐 𝑚𝑡
1+ = (1 + 𝑟𝑠 𝑡)
𝑚
 𝑟𝑐 𝑚𝑡
1+ = (1 + 𝑟𝑠 𝑡)
𝑚

𝑟𝑐 𝑚𝑡
1+ −1
𝑟𝑠 = 𝑚
𝑡
 𝑟𝑐 𝑚𝑡
1+ = (1 + 𝑟𝑠 𝑡)
𝑚

1/𝑚𝑡
𝑟𝑐
1 + 𝑟𝑠 𝑡 =1+
𝑚
1/𝑚𝑡
𝑟𝑐
1 + 𝑟𝑠 𝑡 −1=
𝑚
1/𝑚𝑡 1
𝑟𝑐 = 𝑚 1 + 𝑟𝑠 𝑡 −1
1. What simple interest rate is equivalent to 5
½ % compounded semi-annually, if money
is invested for 5.5 years?
𝑟𝑐 𝑚𝑡
1+ = (1 + 𝑟𝑠 𝑡)
𝑚
2𝑥5.5
.055
1+ = (1 + 𝑟𝑠 𝑥5.5)
2
𝑟𝑠 = 6.32%
Find the simple interest rate
equivalent to 10% compounded
quarterly for 3 years and 4 months.
𝑟𝑐 𝑚𝑡
1+ = (1 + 𝑟𝑠 𝑡)
𝑚
4
4𝑥(3 )
.10 12 4
1+ = (1 + 𝑟𝑠 𝑥 3
4 12
𝑟𝑠 = 11.697%
1. What rate compounded quarterly is
equivalent to simple interest rate:
13.5% for 8 years and 6 months
𝑟𝑐 𝑚𝑡
1+ = (1 + 𝑟𝑠 𝑡)
𝑚
6
𝑟𝑐 4𝑥812 6
1+ = (1 + 0.135 𝑥 8 )
4 12

𝑟𝑐 =9.09%
Ms. Castro plans to invest P100,000 at
1
12 % simple interest for three years.
2
At what rate compounded semi-
annually could she just as well invest for
the same period of time?
• If term is 15 months, what rate
compounded quarterly is
equivalent to 12%
• a.) simple interest?
• b.) compounded semi annually?