What is an effective annual interest rate?
October 17, 2023 4 min read
Whether you’re borrowing money for a meaningful purchase or setting aside savings for your future goals, an account’s interest rate will affect how much you pay or earn.
However, the interest rate alone doesn’t tell you the whole story. You also have to consider whether the interest compounds and, if it does, how frequently it compounds. When you include the effects of compounding, you can calculate the effective annual interest rate.
- The effective annual interest rate is the interest rate of a loan or investment based on how much interest accrues over a year if you include compounding.
- Nominal interest rates don’t include compounding, so they won’t necessarily tell you how much you’ll owe or earn over time.
- In the U.S., annual percentage yields (APYs) and annual percentage rates (APRs) are more common than EAIRs on savings and borrowing products, respectively.
Effective annual interest rate explained
The effective annual interest rate is the annualized interest rate if you include compounding. It can tell you how much interest accrues with compounding, but it still excludes financing charges and principal payments. It’s sometimes called the EAIR, annual equivalent rate (AER), the effective annual rate (EAR) or the effective interest rate (EIR).
How does the effective annual interest rate work?
The nominal interest rate on your loan or savings determines how much interest applies to the principal balance. But it doesn’t necessarily tell you how much interest accrues over the year.
When interest compounds—interest accrues on the previously earned interest—the total interest amount can increase. And the rate of compounding—such as daily, monthly, quarterly or annually—affects how quickly the interest accrues.
The effective annual interest rate uses the nominal interest rate and compounding frequency to tell you the interest rate based on how much interest actually accrues over the year.
Effective annual interest rate formula
The formula for calculating the effective annual interest rate looks like this:
Effective annual interest rate example
Suppose you open a 12-month certificate of deposit (CD) with a 5% interest rate and deposit $10,000. If the interest compounds annually, you’ll have $10,500 at the end of the year—the 5% nominal interest rate is the same as the effective annual interest rate.
But if the interest compounds semiannually—twice a year—the effective annual interest rate will be slightly higher. And the more frequently the interest compounds, the larger the difference.
Consider if the interest compounds monthly. You earn $41.67 at the end of the first month, and the 5% interest rate applies to your new $10,041.67 balance for month two. It keeps compounding, and by the end of the year, you will have $10,511.62.
The nominal rate is still 5%. But your effective annual interest rate is 5.116% because that reflects how much interest you actually earned over the year.
Effective annual interest rate compared to other types of interest rates
There are different ways of evaluating the returns on loans and investments, and these are reflected in different interest-related terms. In some cases, there are even laws that require financial institutions to use or advertise particular types of rates.
Here are some of the common terms you might find related to effective interest rates:
Nominal interest rate vs. effective annual interest rate
The nominal interest rate is sometimes called the stated interest rate because it’s the interest rate that’s stated on the account. It doesn’t include any fees or compounding.
The effective annual interest rate and nominal interest rate will be the same if interest compounds annually. However, the more frequently the interest compounds, the higher the effective annual interest rate and the larger the difference between the two.
Real interest rate vs. effective annual interest rate
If you’re investing your money, you might want to consider the real interest rate, which is the nominal interest rate minus the inflation rate. Because inflation can diminish your money’s purchasing power, the real interest rate can help you calculate the value you’ll earn from the investment.
Because the real interest rate solely depends on the nominal and inflation rates, it also doesn’t consider compounding. You could subtract the inflation rate from the effective annual interest rate if you want to find real interest rates, including compounding.
APY vs. effective annual interest rate
APR vs. effective annual interest rate
For example, the APR may be higher than the nominal interest rate or effective annual interest rate on a loan if the loan has an origination fee because you’re paying more money overall. If there aren’t any fees, the APR will be the same as the nominal rate.
For credit cards, the APR and interest rate are the same thing—neither includes fees or compounding. But credit cards work differently than other loans, and your cost of using the card can also depend on the card’s fees and whether you revolve a balance.
Effective annual interest rate in a nutshell
Effective annual interest rates can help you understand how much interest you’ll actually earn when you’re saving or investing or how much you’ll have to pay when you’re borrowing. These can be important if you’re learning about financial literacy concepts and striving to achieve specific financial goals.