what the effective annual interest rate tells you
a certificate of deposit cd a savings account or a loan offer may be advertised with its nominal interest rate and effective annual interest rate the nominal interest rate does not reflect the effects of compounding interest or even the fees that come with these financial products the effective annual interest rate is the real return or interest payment that s why the effective annual interest rate is an important financial concept to understand you can compare various offers accurately only if you know their effective annual interest rates example of effective annual interest rateconsider these two offers investment a pays 10 interest compounded monthly investment b pays 10 1 compounded semiannually which is the better offer in both cases the advertised interest rate is the nominal interest rate the effective annual interest rate is calculated by adjusting the nominal interest rate for the number of compounding periods that the financial product will undergo in this case that period is one year the formula and calculations are as follows investment b has a higher stated nominal interest rate but the effective annual interest rate is lower than the effective rate for investment a this is because investment b compounds fewer times over the course of the year if an investor were to put 5 million into one of these investments the wrong decision would cost more than 5 800 per year the effective annual interest rate is important because borrowers might underestimate the true cost of a loan without it and investors need it to project the actual expected return on an investment such as a corporate bond effect of the number of compounding periodsas the number of compounding periods increases so does the effective annual interest rate quarterly compounding produces higher returns than semiannual compounding monthly compounding produces higher returns than quarterly and daily compounding produces higher returns than monthly below is a breakdown of the results of these different compound periods with a 10 nominal interest rate there is a ceiling to the compounding phenomenon even if compounding occurs an infinite number of times not just every second or microsecond but continuously the limit of compounding is reached with 10 the continuously compounded effective annual interest rate is 10 517 the continuous rate is calculated by raising the number e approximately equal to 2 71828 to the power of the interest rate and subtracting one in this example it would be 2 71828 0 1 1 effective annual interest rate vs nominal interest ratethe primary difference between an effective annual interest rate and a nominal interest rate is the compounding periods the nominal interest rate is the stated interest rate that does not take into account the effects of compounding interest or inflation for this reason it s sometimes also called the quoted or advertised interest rate on the other hand the ear considers the effects of compounding interest it represents the true annual interest rate after accounting for the impact of compounding interest and it is typically higher than the nominal interest rate in this context the ear may be used as opposed to the nominal rate when communicating rates in an attempt to lure business for example if a bank offers a nominal interest rate of 5 per year on a savings account and compounds interest monthly the effective annual interest rate will be higher than 5 therefore the bank might consider promoting the account at the ear because that rate will appear higher understand the psychological marketing approach of communicating effective annual interest rates for industries that want to boast higher rates ear is best for industries that want to downplay costs nominal rates are best uses of effective annual interest rateseffective annual interest rates are used in various financial calculations and transactions this includes but isn t necessarily limited to the following types of analysis limitations on effective annual interest ratesthough broadly used across the financial sector ear has several downsides the ear calculation assumes that the interest rate will be constant throughout the entire period i e the full year and that there are no fluctuations in rates however in reality interest rates can change frequently and rapidly often impacting the overall rate of return most ear calculations also do not consider the impact of transaction service or account maintenance fees these can also affect the total return ear calculations usually do not consider the impact of taxes on the returns taxes can significantly reduce the actual returns on investments or savings and it s important to factor them into any analysis though a given individual may truly earn at the ear their true return may be reduced by 20 or higher based on what individual tax bracket they reside in ear quotes are often unsuitable for short term investments because there are fewer compounding periods more often ear is used for long term investments as the impact of compounding may be significant this approach may limit the vehicles in which ear is calculated or communicated lastly as the ear calculation is a single rate it does not calculate communicate or convey any risk associated with the investment or loan higher returns often come with higher risk and it s important to consider the risk associated with an investment or loan before deciding just because a vehicle has a higher ear does not necessarily make it the ideal opportunity for every individual considering varying investment preferences or risk tolerances 