The term “effective annual interest rate” refers to the actual return on an investment, taking into account the effect of periodic interest compounding. Effective annual interest rates are of significance only when considering investment choices that are considered very safe because the principal invested doesn't vary, and growth is due primarily or solely due to the crediting of interest at a predetermined rate. The rates themselves are important to investors who are considering among different investment opportunities that have different interest compounding or crediting rules.
Most modern investments that earn interest do so by a system called compounding, which means that the interest, once earned, is added to the principal in the account, after which the interest itself is included with the principal in the calculation of all future interest payments. Another system, called simple interest, does not add interest payments made before maturity to the principal, but usually disburse it directly to the account owner. An exception to the practice of compounding interest is investing in long-term bonds, most of which pay on a simple-interest basis, delivering periodic interest checks to bondholders while their account balances remain static.
Consumers shopping for safe investments whose growth is from periodic compounding of interest payments should be very concerned with the effective annual interest rate because it's a better indicator of the actual return than a statement of the annual interest rate. For example, in the United States, most certificates of deposit (CDs) of one year's length or less, pay interest just once, upon maturity, unless otherwise stated. Some CDs, though, and other savings plans, calculate interest earned at the end of every month or quarter.
However, if two one-year CDs offered the same interest rate, but one paid it as simple interest at the end of the year, and the second compounded and credited the interest monthly, the second would be the better investment, because the interest earned after the first month would be calculated not only on the principal, but on the interest already credited to the account.
For example, a one-year, $10,000 US dollars (USD) CD that pays 10% simple interest will earn $1,000 in interest at maturity. The same $10,000 USD invested in a savings account paying 10% compounded monthly will earn interest at the rate of 0.833% per month, or $83.33 USD at the end of the first month, $84.03 USD at the end of the second month and so on until at the end of the 12th month, it will have earned $1047.13 USD interest, making the effective annual interest rate 10.4713%. If the $10,000 USD were placed in an account that compounded interest daily, the first day's interest would be $2.74 USD, and the total interest paid after 365 days would be $1051.56 USD, for an effective annual interest rate of 10.5156%
Increasing the number of periodic interest payments, then, will increase the effective annual interest rate, which is why the concept is important for investors, especially for those seeking secure, short-term savings products.
Another frequently used term, “Annual Percentage Rate,” or APR, is used to give borrowers a frame of reference for comparing interest rates charged on loans. It's calculated in a different manner because in most cases, periodic loan payments reduce the principle outstanding on a loan; additionally, the fees and other charges associated with a loan may be included in the calculation.
