EFFECTIVE RATE OF

INTEREST
BY: ENGR. RIZAMIN SEVILLA
◦ An effective annual interest rate is the real return on a savings account or any
interest-paying investment when the effects of compounding over time are
taken into account. It also reflects the real percentage rate owed in interest on
a loan, a credit card, or any other debt.
KEYWORDS
•The effective annual interest rate is the true interest rate on an investment or loan because it
takes into account the effects of compounding.
•The more frequent the compounding periods, the higher the rate.
•A savings account or a loan may be advertised with both a nominal interest rate and an effective
annual interest rate.
•The effective annual interest rate is the rate that should be compared between loans and
investment rates of return.
•The effective annual interest rate does not communicate risk, incorporate fees, or factor in tax
implications.
Difference between the Nominal Interest and Effective Rate of
Interest
Nominal Rate is defined as the basic annual rate of interest, it is equal if the
mode of compounding is per annum or annually.
Effective Rate of Interest is defined as the actual or the exact rate of interest
earned on the principal during one year period.
FORMULA

ER = [1 +(NR / m) ] m -1

WHERE:
NR – Nominal Rate, %
m – Number of Compoundings
A man borrowed P 100, 000 at the interest rate of 12% per annum, compounded quarterly.
What is the Effective rate of interest?
Given :
NR -12 %
M- Quarterly so 4
ER = [1 +(NR / m) ] m -1
ER = [1 +(12% / 4) ] 4 -1
ER =12.55%
What is the corresponding effective rate of 18% compounded semi-quarterly?
Given:
NR – 18%
m – Compounded semi- quarterly so 8
ER = [1 +(NR / m) ] m -1
ER = [1 +(18% / 8) ] 8 -1
=19. 48%
A bank pays one percent interest on savings account four times a year. The effective rate is ?
Given :
NR – 1%
n – Four times a year or quarterly so 4
ER = [1 +(NR / m) ] m -1
ER = [1 +(1% / 4) ] 4 -1
=1%
An interest rate is quoted as being 7.5% compounded quarterly. What is the effective annual
interest rate?
Given:
NR – 7.5%
n – Quarterly so 4
ER = [1 +(NR / m) ] m -1
ER = [1 +(75% / 4) ] 4 -1
=7.71%