How to Calculate an Effective Rate of Return
The effective rate of return on a series of cash flows takes compounding into account. If an investment pays 3 percent annually, and there's no compounding, then the effective rate of return is also 3% percent. If the investment compounds monthly, then the effective rate of return is higher than 3 percent.
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Significance
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Effective interest is significant for two reasons. First, it's more accurate. Simple interest only estimates returns. Effective interest, on the other hand, captures the detail needed to properly account for time and compounding. Second, effective interest is much more common: Very few instruments are based on simple interest calculations.
Function
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Effective interest serves as a method to determine real returns on investments and includes a wide variety of money market instruments, loans and other types of investments.
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Benefits
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Effective interest benefits from the fact that it's easy to compute with a good calculator. It also allows investors to be more accurate in estimating returns generated by cash flows.
Process
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The process involves basic math to covert a simple interest rate to a compounding effective interest rate using exponents to take account of the time periods involved.
Calculate
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Write down the annual rate as a decimal. For 3%, for example, express it as 0.03. Divide 0.03 by the number of periods. For monthly compounding in a year, this is 0.03 divided by 12, which equals 0.0025. Add 1 to 0.0025 to get 1.0025. Raise this to the power of 12 for monthly compounding: 1.00255^12 equals 1.0304. Subtract 1 to get 0.0304.
Convert to a Percentage
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Convert to a percentage by multiplying by 100 to get an effective rate of return of 3.04 percent.
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References
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