Effective Interest Rate Definition
Answer:The effective interest rate, also called annual equivalent rate (AER) is the converted rate allowing to compare different loan programs. Since interest rates may be calculated on different compounding terms (daily, monthly, weekly, quarterly, annually, etc.), the effective interest rate formula is in fact converting rates based on different compounding periods to annual ones and makes loans better comparable.
The effective interest rate is not the same as the annual percentage rate (APR) as it does not incorporate one-time costs associated with the loan as APR does.
The effective interest rate will be calculated with the formula:
effective interest rate = (1+i/n)n-1
where i is the nominal rate, and n is the number of compounding periods.
For example, a nominal interest rate of 7% compounded quarterly will be calculated as:
effective interest rate = (1+0.07/4)4-1 = 0.07185.
Or, the effective annual interest rate will be 7.185%.
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