Information about Effective Annual Rate
The effective interest rate, effective annual interest rate, or simply effective rate is the interest rate on a loan or financial product restated from the nominal interest rate as an interest rate with annual compound interest.[1]
Since an interest rate may be defined using different compounding terms (daily, monthly, annually, or other), the annual "cost" of interest between two different loans may not be comparable. The effective interest rate is used to make such loans more comparable by converting any loan into the equivalent annual rate.
The effective interest rate differs in two important respects from annual percentage rate: first, the effective interest rate generally does not incorporate one-time charges such as front-end fees or other "unusual" features; second, the effective interest rate is (generally) not a term defined by legal or regulatory authorities (as annual percentage rate is in many jurisdictions).
Annual Percentage Yield or effective annual yield is the analogous concept used for savings or investment products, such as a certificate of deposit. Since any loan is an investment product for the lender, the terms may be used to apply to the same transaction, depending on the point of view.
It is important to note that effective annual interest or yield may be calculated or applied differently depending on the circumstances, and the definition should be studied carefully. For example, a bank may refer to the yield on a loan portfolio after expected losses as its effective yield and include income from other fees, meaning that the interest paid by each borrower may differ substantially from the bank's effective yield.
For example, a nominal interest rate of 6% compounded monthly is equivalent to an effective interest rate of 6.17%. 6% monthly is credited as 6%/12 = 0.5% every month. After one year, the initial capital is increased by the factor (1+0.005)12 ≈ 1.0617. (n.b.: Percentage figures must always be divided by 100, as the percent sign is a notation convenience; e.g. 6% = 0.06).
When the frequency of compounding is increased up to the infinity the calculation will be:
Since an interest rate may be defined using different compounding terms (daily, monthly, annually, or other), the annual "cost" of interest between two different loans may not be comparable. The effective interest rate is used to make such loans more comparable by converting any loan into the equivalent annual rate.
The effective interest rate differs in two important respects from annual percentage rate: first, the effective interest rate generally does not incorporate one-time charges such as front-end fees or other "unusual" features; second, the effective interest rate is (generally) not a term defined by legal or regulatory authorities (as annual percentage rate is in many jurisdictions).
Annual Percentage Yield or effective annual yield is the analogous concept used for savings or investment products, such as a certificate of deposit. Since any loan is an investment product for the lender, the terms may be used to apply to the same transaction, depending on the point of view.
It is important to note that effective annual interest or yield may be calculated or applied differently depending on the circumstances, and the definition should be studied carefully. For example, a bank may refer to the yield on a loan portfolio after expected losses as its effective yield and include income from other fees, meaning that the interest paid by each borrower may differ substantially from the bank's effective yield.
Calculation
The effective interest rate is calculated as if compounded annually. The effective rate is calculated in the following way, where r is the effective annual rate, i the nominal rate, and n the number of compounding periods per year (for example, 12 for monthly compounding):
For example, a nominal interest rate of 6% compounded monthly is equivalent to an effective interest rate of 6.17%. 6% monthly is credited as 6%/12 = 0.5% every month. After one year, the initial capital is increased by the factor (1+0.005)12 ≈ 1.0617. (n.b.: Percentage figures must always be divided by 100, as the percent sign is a notation convenience; e.g. 6% = 0.06).
When the frequency of compounding is increased up to the infinity the calculation will be:
See also
- Time value of money
- Interest
- Compound interest
- List of finance topics
- Real interest rate
- Real versus nominal value
References
This article or section needs copy editing for grammar, style, cohesion, tone and/or spelling.
You can assist by [ editing it] now. A how-to guide is available, as is general .
This article has been tagged since February 2007.
..... Click the link for more information.
You can assist by [ editing it] now. A how-to guide is available, as is general .
This article has been tagged since February 2007.
..... Click the link for more information.
In finance and economics, nominal interest rate or nominal rate of interest refers to the rate of interest before adjustment for inflation (in contrast with the real interest rate); or, for interest rates "as stated" without adjustment for the full effect of compounding
..... Click the link for more information.
..... Click the link for more information.
Compound interest is the concept of adding accumulated interest back to the principal, so that interest is earned on interest from that moment on. The act of declaring interest to be principal is called compounding (i.e. interest is compounded).
..... Click the link for more information.
..... Click the link for more information.
Annual Percentage Rate (APR) is an expression of the effective interest rate that the borrower will pay on a loan, taking into account one-time fees and standardizing the way the rate is expressed.
..... Click the link for more information.
..... Click the link for more information.
Annual Percentage Yield (APY) expresses an annual rate of interest taking into account the effect of compounding, usually for deposit or investment products (such as a certificate of deposit). It is analogous to the Annual percentage rate (APR), which is used for loans.
..... Click the link for more information.
..... Click the link for more information.
Yield may mean:
..... Click the link for more information.
- Crop yield, a measure of the output per unit area of land under cultivation
- Maximum sustainable yield, the largest long-term fishery catch that can be safely taken
- Rolled throughput yield, a statistical tool in Six Sigma
..... Click the link for more information.
certificate of deposit or CD is a time deposit, a financial product commonly offered to consumers by banks, thrift institutions, and credit unions.
Such CDs are similar to savings accounts in that they are insured and thus virtually risk-free; they are "money in
..... Click the link for more information.
Such CDs are similar to savings accounts in that they are insured and thus virtually risk-free; they are "money in
..... Click the link for more information.
bank is a commercial or state institution that provides financial services , including issuing money in various forms, receiving deposits of money, lending money and processing transactions and the creating of credit.
..... Click the link for more information.
..... Click the link for more information.
The time value of money is based on the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal.
..... Click the link for more information.
..... Click the link for more information.
This article or section needs copy editing for grammar, style, cohesion, tone and/or spelling.
You can assist by [ editing it] now. A how-to guide is available, as is general .
This article has been tagged since February 2007.
..... Click the link for more information.
You can assist by [ editing it] now. A how-to guide is available, as is general .
This article has been tagged since February 2007.
..... Click the link for more information.
Compound interest is the concept of adding accumulated interest back to the principal, so that interest is earned on interest from that moment on. The act of declaring interest to be principal is called compounding (i.e. interest is compounded).
..... Click the link for more information.
..... Click the link for more information.
Topics in finance include:
..... Click the link for more information.
Fundamental financial concepts
- Finance an overview
- Arbitrage
- Capital (economics)
..... Click the link for more information.
Nominal interest rates include all three risk factors, plus the time value of the money itself. Real interest rates include only the systematic and regulatory risks and are meant to measure the time value of money.
..... Click the link for more information.
..... Click the link for more information.
In economics, the nominal values of something are its money values in different years. Real values adjust for differences in the price level in those years. Examples include a bundle of commodities, such as gross domestic product, and income.
..... Click the link for more information.
..... Click the link for more information.
This article is copied from an article on Wikipedia.org - the free encyclopedia created and edited by online user community. The text was not checked or edited by anyone on our staff. Although the vast majority of the wikipedia encyclopedia articles provide accurate and timely information please do not assume the accuracy of any particular article. This article is distributed under the terms of GNU Free Documentation License.
Herod_Archelaus
