Factors

• The effective rate of interest depends on the annual interest rate and the number of times per year that interest compounds. The more times per year that interest compounds, the higher the effective rate of interest. Common compounding periods include daily, weekly, monthly, quarterly and semiannually. For example, some savings accounts may compound interest daily, while others may compound interest monthly.
  
  

Calculation

• To figure the effective interest rate, divide the annual interest rate by the number of times per year interest is compounded to find the periodic rate. Next, add 1 to the periodic rate. Then, raise the result to the power of the number of times interest compounds per year. Finally, subtract 1 from the result to find the effective interest rate.
  
  For example, if you have an annual rate of 7.2 percent, compounded semiannually, divide 0.072 by 2 to get 0.036. Add 1 to 0.036 to get 1.036. Raise 1.036 to the second power to get 1.073296. Subtract 1 from 1.073296 to get 0.073296, or 7.33 percent as the effective interest rate.
  
  

Applications

• When you take out a loan or put money into a savings account, you will benefit from knowing the difference between the simple interest rate and the effective interest rate. For example, a savings account might pay interest on a monthly basis, which would make the effective rate of interest higher than the annual interest rate. The result is you're paid more interest. However, if you have a loan that compounds interest weekly, you would end up paying a higher effective rate of interest than you would with an annual rate.
  
  

Significance

• Knowing the effective rate of interest is significant because you can end up paying (in the case of a loan) or earning (in the case of a savings account) more than you expected. When comparing loans and investments, the effective rate of interest gives you a more accurate comparison between different options, which can save you money over the life of the account or loan. The greater the investment, the greater the impact.