Rate: Interest rate quoted based on an annual period.
Effective Interest Rate: Actual
interest earned or paid in a year or some other time period.
Given the nominal interest rate per
year, r, and the number of interest periods per year, m,
the effective annual interest rate, ia, can be
computed as follows:
ia = (1 + r/M)M - 1
Nominal annual interest rate is listed at 10.0% and the loan is
compounded monthly. Determine the Effective Annual Interest rate.
ia = (1 + .10/12)12 - 1
The use of the word "effective" is not
intuitively clear. This term is used for rates of interest in which
interest is paid once per measurement period. This will be
contrasted with "nominal" rates of interest, in which interest is
paid more frequently than once per measurement period.
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