1. What is Effective Interest Rate?

The effective interest rate (also called the equivalent annual rate) is the actual interest rate on a loan or financial product when compounding over multiple periods is taken into account. For mortgages with monthly compounding, this will be higher than the nominal rate.

2. How Does the Calculator Work?

The calculator uses the effective rate formula:

Where:

• \( \text{Nominal} \) — Annual nominal interest rate (in decimal form)
• 12 — Number of compounding periods per year (monthly)

Explanation: The formula accounts for the effect of monthly compounding on the nominal rate, showing the true annual cost of borrowing.

3. Importance of Effective Rate Calculation

Details: Understanding the effective rate helps borrowers compare different mortgage offers accurately, as lenders may quote different compounding frequencies.

4. Using the Calculator

Tips: Enter the nominal annual interest rate as a percentage (e.g., 5.25 for 5.25%). The calculator will show the equivalent effective annual rate.

5. Frequently Asked Questions (FAQ)

Q1: Why is effective rate higher than nominal rate?
A: Because of compounding - interest earns more interest when compounded more frequently than annually.

Q2: How does this affect my mortgage payments?
A: While payments are calculated using the nominal rate, the effective rate shows the true annual cost of borrowing.

Q3: What if my mortgage compounds differently?
A: The formula changes based on compounding frequency. For quarterly compounding, use 4 instead of 12.

Q4: Is APR the same as effective rate?
A: APR includes fees while effective rate only considers interest compounding, but both show true borrowing costs.

Q5: How much difference does this typically make?
A: For a 5% nominal rate, the effective rate is about 5.12% - small but significant over a 30-year mortgage.