What is the effective annual rate

Know what the effective annual rate is, its impact on costs, and why it's crucial in finance.
Personal loan
5 min read
05 February 2024

When a borrower pays interest on a loan, such as a mortgage, the lender's advertised interest rate is termed the nominal rate or stated interest rate. However, this rate does not consider the impact of compounding, i.e., having multiple interest payments per year. In contrast, the effective annual rate (EAR) accounts for compounding and provides a more accurate calculation of accruing interest.

What is effective annual rate?

The effective annual rate, also known as the effective annual interest rate, is the actual percentage of interest a borrower pays on their loan. The nominal rate and the number of compounding periods per year determine the effective annual rate. Importantly, EAR is not influenced by the invested amount, offering a more precise measure of the true interest cost.

Importance of the effective annual interest rate

Understanding the effective annual interest rate especially when borrowing a loan such as a personal loan is essential for making smart financial choices. While nominal interest rates provide a basic overview, they do not consider how often interest is compounded. The EAR ensures a more precise assessment of the cost of borrowing. This is particularly important when comparing different financial products or loans, as it reveals the true cost over time.

Effective annual interest rate formula

We calculate the effective annual interest rate using a formula that considers both the nominal interest rate and the compounding frequency. The formula is straightforward:

EAR=(1+i/n) ^n −1

Where:

i=Nominal interest rate

n=Number of periods​

You can also use the personal loan EMI calculator to compute EMIs effortlessly.

What is the difference between the annual interest rate and the effective interest rate?

The annual interest rate and effective interest rate may sound similar, but they have a crucial difference. The annual interest rate, also known as the nominal rate, is the straightforward interest rate specified by the lender or financial institution. It does not account for compounding.

Alternatively, the effective annual interest rate considers compounding, giving a more accurate understanding of the real cost of borrowing. The difference arises because nominal rates may be compounded more frequently than annually, impacting the overall cost over time.

In summary, while the annual interest rate gives a basic overview, the effective interest rate provides a more detailed understanding, incorporating the impact of compounding for a more accurate financial assessment.

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