How to Calculate an Effective Interest Rate on a Security Purchased at a Discount
Certain investment types allow investors to purchase securities at a discount of the face value of the security. For example, you might purchase a zero-coupon certificate of deposit for 94 cents for every dollar it is worth and in a specified period of time, you could redeem the security for its face value. Since these securities do not list an interest rate, you need to calculate the effective interest rate to figure out how the rate of return compares to other rates. Typically, the effective interest rate is measured per year.
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Instructions
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Divide the maturity value of the security by the discounted price you paid for the security. For example, if you paid $4,640 for a CD with a face value of $5,000 in two years, divide $5,000 by $4,640 to get 1.077586206896552.
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Divide 1 by the number of years until the security matures. For this example, divide 1 by 2 to get 0.5.
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Raise the Step 1 result to the power of Step 2. In this example, raise 1.077586206896552 to the 0.5 power to get 1.038068498.
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Subtract 1 from the result to find the effective interest rate expressed as a decimal. In this example, take away 1 from 1.038068498 to get 0.038068498.
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Multiply the effective interest rate expressed as a decimal by 100 to find the effective interest rate expressed as a percentage. Completing the example, multiply 0.038068498 by 100 to find the effective interest rate equals about 3.81 percent per year.
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