Effective Annual Interest Rate

Effective annual interest rate is the actual interest rate one pays on the loan per year. It differs from the nominal interest rate when compounding takes place more than once in a year. It is calculated by:

Effective annual interest rate=(1+i/n)^n-1 where i=nominal annual rate n=periods

Consider a nominal annual rate of 10%. Compounded yearly, this rate will turn $1000 into $1100. However, if compounding occurs monthly, $1000 would grow to $1104.70 by the end of the year, which gives an effective annual interest rate of 10.47%