Question:

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%.

Mortgage rates hit their lowest since 1955. Ask the home loan experts we recommend Quicken Loans how to take advantage of them.
Was this Mortgage QnA helpful?
Not at all
  • Currently 2.9/5 Stars
  • 1
  • 2
  • 3
  • 4
  • 5
Definitely
Add to this Answer

Mortgage QnA is not a common forum. We have special rules:

  • Post no questions here. To ask a question, click the Ask a Question link
  • We will not publish answers that include any form of advertising
  • Add your answer only if it will contrubute to the quality of this Mortgage QnA and help future readers
If you have trouble reading the code, click on the code itself to generate a new random code. Verification Code Above:
Bookmark and share this QnA: