What Is the Difference Between a Stated Interest Rate & an Effective Interest Rate?

When banks state the interest rate, you need know whether you are looking at the stated interest rate or the effective interest rate. The effective interest rate is a better measure of how much interest will accrue on the account.

Interest Compounding

The effective interest rate takes into account interest compounding, while the stated interest rate does not. Compound interest is calculated on the principal as well as the interest that the principal has already earned.

Effects

The effective interest rate will be higher than the stated interest rate as long as interest is compounded more than once per year, such as monthly or quarterly compounding. If interest is compounded only once per year, the stated interest rate will be the same as the effective interest rate.

Conversion

To convert from the stated interest rate to the effective interest rate, divide the stated interest rate expressed as a decimal by the number of times per year the interest compounds, add 1, raise the result to the Cth power, with C equaling the number of times per year interest compounds, and subtracting 1. For example, if you had a 12 percent stated interest rate that compounded interest monthly, you would divide 0.12 by 12 to get 0.01, add 1 to get 1.01, raise 1.01 to the 12th power to get 1.12682503 and subtract 1 to get 0.1268, or an effective rate of 12.68 percent.

References

• United Nations Capital Development Fund: Effective Interest Rate