Effective Annual Rate Calculation Examples Help

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Effective Annual Rate Calculation Examples Meaning


Effective Annual Rate is basically the interest rate which an investor earns in a year after taking into account the effects of compounding. It is one of the useful measures for evaluating the true return on an investment. It is the actual return on a deposit which is arrived after considering the number of times interest is paid over a period of a year.

The formula for calculating effective annual interest rate is:(1 + i / n)n – 1

i stands for the annual interest rate that was stated
n represents the number of compounding periods in one year

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Effective Annual Rate Calculation Examples Explanation


Let’s take an example and understand the concept better.
Example: let’s assume that a certificate of deposit with a 12% annual interest rate is purchased. If the bank compounds the interest every month then using this information and the formula above, the effective annual interest rate on the certificate of deposit is

(1 + .12/12)12 – 1 = .12683 or 12.683%

The effective annual interest rate is an important concept in finance as it helps to compare different investments that calculate compounded interest differently and helps investors in making investment decisions.

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