Effective Interest Rate

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The effective interest rate (EIR), effective annual interest rate, annual equivalent rate (AER) or simply effective rate is the interest rate on a loan or financial product restated from the nominal interest rate and expressed as the equivalent interest rate if compound interest was payable annually in arrears.

It is used to compare the interest rates between loans with different compounding periods, such as weekly, monthly, half-yearly or yearly. The effective interest rate sometimes differs in one important respect from the annual percentage rate (APR): the APR method converts this weekly or monthly interest rate into what would be called an annual rate that (in some parts of the world) doesn’t take into account the effect of compounding.

By contrast, in the EIR, the periodic rate is annualized using compounding. It is the standard in the European Union and many other countries around the world. The EIR is precise in financial terms, because it allows for the effects of compounding, i.e. the fact that for each period, interest is not calculated on the principal, but on the amount accumulated at the end of the previous period, including capital and interest. This reasoning is easily understandable when looking at savings.

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