What Is the Effective Annual Rate?
Definition
Effective annual rate: The yearly rate including the effect of compounding: (1 + r/n)^n − 1.
The effective annual rate is the yearly rate that includes the effect of interest being added to the balance during the year. It is (1 + r/n)^n − 1, where r is the nominal annual rate and n the number of compounding periods per year. For example, a nominal 12% compounded monthly equals about 12.68%.
How it differs from the nominal rate
The nominal rate ignores how often interest is added. When interest is added once a year, the two rates are equal. The more often interest is added, the higher the effective rate: a nominal 12% compounded daily equals about 12.75%. Compare offers with the effective rate.