Formula and Use
The effective annual rate formula calculates the rate of interest for a year based on a nominal rate (i) compounded a number of times a year (m).
The effective annual rate is sometimes abbreviated to EAR and often referred to as the annual equivalent rate or AER.
The Excel EFFECT function can be used instead of the effective annual rate formula, and has the syntax shown below.
Effective Annual Rate Formula Example
If the nominal rate is 9% compounded quarterly, what is the effective annual rate?
The effective interest rate for the year is calculated using the effective annual rate formula as follows:
Effective annual rate = (1 + i / m )m - 1 i = annual nominal rate = 9% m = compounding periods in a year = 4 Effective annual rate = (1 + 9% / 4 )4 - 1 Effective annual rate = 9.308%
The same answer can be obtained using the Excel EFFECT function as follows:
Effective annual rate = EFFECT(i,m) i = 9% m = 4 Effective annual rate = EFFECT(9%, 4) Effective annual rate = 9.308%
The effective annual rate formula is one of many used in time value of money calculations, discover another at the links below.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.