How Effective Interest Works

• Effective interest is an accurate interest expression. If an account, for example, gets 6 percent interest (an annual figure) on $3,000 of initial investment, you'd get $180 in interest at year's end. If your interest accrues monthly, though, you would instead receive 0.5 percent interest monthly. Here, that would be $15. Now, if that's compounded -- added to existing account funds -- each month, you'd get interest on that $15 and all the compounded funds each month. That would make the effective interest more than 6 percent.
  
  

Use and Reporting of Effective Interest

• The main difference between the effective interest method (or annual percentage yield, a synonymous term abbreviated APY) and an annual percentage rate, or APR, is the compounding factor. For a loan, a bank may express the APR as 12 percent. Each year, 12 percent of the principal is aggregated to what you owe. With effective interest, the difference shows up when interest is paid at various times of the year. For the same 12 percent interest -- this time applied to a money market account and compounded monthly -- you're effective interest is around 12.7 percent. It is more beneficial to a bank to report returns to consumers this way.
  
  

Calculate Effective Interest Return

• To calculate effective interest return, multiply your investment by the percentage figure. Here, that's $119, your interest return for the year. Add that to the investment. Thus, $3,400 at a 3.5 percent effective rate is $3,519. That's your investment total at year's end.
  
  

Comparing Interest Rates

• Look for the highest interest rate; however, check actual yields. Two identical rates may not accrue identical yields should they use different methods. Find out as well about the frequency of compounding. Other terms being equal, faster compounding gets the cash earning interest right away.