What Is an Effective Interest Rate?: Compounding and Your Interest Costs
That’s because there’s more than one way to express interest, and they don’t all account for the effect of compounding. Effective interest does, which means it can give you a more accurate view of your interest rate.
If all that sounds complicated, don’t worry. We’re going to break down exactly what effective interest rates are, how they work, and how you can use them to make sure you’re getting the best deal.
Effective interest 101
There are two primary ways to express an interest rate, whether it’s for saving or borrowing: with a nominal interest rate or an effective interest rate. Nominal interest doesn’t take compounding into account, while effective interest does.
But, uh, what is compounding?
You might remember hearing about compounding back in high school algebra (sorry to bring that up). But in case you’ve forgotten (we don’t blame you), let’s refresh.
Compounding basically means that interest gets calculated on your money, and then that interest gets added to your principal (the initial amount of money). So the next time interest gets calculated, it will be a percentage of both your principal and your previous interest.
Different banks and lenders compound interest at different frequencies. The compounding period, or the time between interest calculations, describes this frequency.
Sometimes interest gets compounded quite frequently, but that’s not always the case. In fact, all of the following are common compounding periods:
So if you have daily compounding interest, your interest will get calculated every day. If you have semiannually compounding interest, it only gets calculated every six months.
Your compounding period can make a big difference in your effective interest, but we’ll get to that in a minute. For now, back to nominal and effective interest.
Not all loans or savings accounts use compound interest. Some use simple interest instead, in which case you only ever pay interest on the initial principal amount.
Effective interest vs. nominal interest
As we said above, a nominal interest rate (sometimes called a stated interest rate) doesn’t include the effect of compounding on the rate. Or, put another way, it assumes that you have an annual compounding period.
But in many cases, that’s not true. Many (if not most) lenders and banks have non-annual compounding periods. So if you’re just looking at a nominal interest rate, you’re not getting an accurate picture of how much interest you’re actually accruing over time (thanks to compounding).
That’s where effective interest comes in. It uses your nominal interest rate and your compounding frequency to calculate how much interest you’re actually accruing.
If you want to calculate your effective annual interest rate yourself, you can use this formula (with i referring to the nominal interest and n referring to the number of compounding periods in one year):
r = (1+i/n)n - 1
Or make it easy on yourself (and annoy that high school math teacher) by just using an effective interest calculator.
In theory, this gives you a more accurate understanding of what you’ll pay or earn over time. And using effective annual interest can help you get more accurate results from a business loan calculator.
Because as it turns out, compounding can make a big difference on interest.
Effect of compounding interest
If you remember that high school math class, you may already know that the shorter the compounding period, the more interest you accrue.
For example, a daily compounding frequency will earn more interest than a monthly compounding frequency. That monthly frequency, in turn, will earn more than an annual frequency would.
You can see that for yourself with this table, which shows how an effective rate changes with different compounding periods:
How compounding periods affect an effective annual rate
Nominal interest rate
As you can see, it’s just as we said: more compounding means more interest.
Now, that increased interest might not seem like a lot. The difference between 0.005% more interest and 0.0025% is, admittedly, rather small. But it adds up.
Take, for example, a $50,000 loan with a 10% nominal interest rate―pretty normal financing. An extra 0.5% of interest (the difference between daily and annual compounding periods) on that $50,000 adds up to another $250. So just imagine the effect when you’ve got a $500,000 loan ($2,500) or a $5 million loan ($25,000).
That’s why effective interest matters so much. A nominal rate gives you only part of the picture, while effective interest gets you closer to the real costs.
But like we said, effective interest can apply to both business loans and savings accounts. So let’s talk about how it applies to each of those.
Effective interest and loans
Let’s start by talking about how effective interest works with business loans.
In most cases, business lenders want to make it seem like you’re paying less in interest. That means that most advertised interest rates you see are nominal interest rates―not effective.
You won’t find many lenders who publicize their compounding frequency either, which can make it hard to calculate the effective interest yourself.
That said, your compounding period will be in any loan paperwork you sign. So make sure you look in your loan contract and run the calculations yourself before you commit to a loan.
Keep in mind, too, that the larger your loan and the higher your interest rate, the bigger the difference compounding will make on your effective interest rate.
Effective interest vs. APR
Depending on how much you know about business loan rates, you might be wondering how effective interest compares to APR.
APR, or annual percentage rate, tries to describe the total cost of a loan over one year―including both interest and fees (our guide to APR explains more). But APR does not account for compounding interest.
On the other hand, effective interest obviously only includes costs from your interest rate. It doesn’t include costs from loan fees.
Neither number gives you a perfect picture of your loan costs, but they’re both useful measures you can use.
Effective interest and effective APR have nothing to do with each other. While effective interest measures the effect of compounding on an interest rate, effective APR tries to measure the cost of financing that doesn’t have an interest rate. Don’t confuse the two.
(You may also want to look at an amortization table that's tailored to your repayment schedule, since this can help you see how much of each monthly payment goes toward interest.)
Effective interest and savings
So what if you’re trying to earn interest through savings?
The same general rules apply. The higher your nominal interest rate and the more frequent your compounding period, the more effective interest matters. (Which is why we prefer high-yield savings accounts to standard savings accounts.)
If you want more specific numbers, you can use your effective rate to calculate the future value of your savings account.
Since banks know you want to earn as much as possible, they often advertise the effective interest rate and not the nominal interest rate.
Effective interest vs. APY
Many banks use APY, or annual percentage yield, to describe their rates. It includes the total interest over one year, including compounding.
It’s pretty much the same thing as effective interest. In fact, the formulas to calculate APY and effective interest are exactly the same.
It’s just more common to use effective interest to describe costs for borrowing, while APY as a term gets used pretty exclusively for interest you earn (hence the “yield” in the name).
Your interest rate might just look like a simple number, but it could be misleading. You’ll need to calculate effective interest if you want to see how compounding affects what you owe or earn.
Your effective interest rate may not be too different from your nominal interest rate, but even small differences can add up. So whether you’re borrowing or saving, it’s worth figuring out your effective rate.
Your interest expense matters, but it’s not the only thing you should consider. Learn more about other things you should factor in when you choose a business loan.
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