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The effective interest rate adjusts the stated nominal rate to allow for the effects of compounding over a specific time period, referred to as the effective period. Different compounding periods earn different amounts of interest and the effective interest rate allows comparisons to be made by converting these to an equivalent rate as if compounding took place once every effective period,
The effective annual rate adjusts the stated nominal rate to allow for the effects of compounding. Different compounding periods earn different amounts of interest and the effective annual rate allows comparisons to be made by converting these to an equivalent rate as if compounding took place once at the end of the year, hence the alternative name of annual equivalent rate (AER).
The Excel NOMINAL function is used to calculate the nominal annual rate (i) required to give an effective annual rate (r), allowing for a given number of compounding periods each year (m). The effective rate allows for compounding, whereas the nominal rate does not allow for compounding.
The Excel EFFECT function is used to calculate the effective annual rate from the nominal annual rate based on the number of compounding periods in a year. The effective annual rate allows for compounding, whereas the nominal annual rate does not allow for compounding.