Effective Interest Rate Formula

Effective Interest Rate Formula

Effective Interest Rate is calculated with the help of following formula.

1+R= (1+i) ⁿ

R= Rate of Interest

I= Rate of interest for period (months, quarter, semiannual)

n= Number of periods (months, quarter, semiannual) in year

Example

A got a credit card from a reputable bank and bank offered him a 3% interest per months. Credit card amount was $ 10,000. Calculate the interest for the year?

R = (1+i) ⁿ-1

= (1.03)¹²-1

=1.4257-1

=.4257

= 42.57%

Interest amount = 10,000 x 42.57 %

=$ 4,257

Purpose of effective Interest Rate

Effective interest rate gives you annual interest cost and an effective tool to measure the different financial product. Effective interest rate takes into account the periodical compounding effect.