The effective annual rate is the true interest rate of a loan when taking into account compounding. Loans may display the nominal interest rate which does not take into account the effects of compounding and therefore, does not give a future value directly. To overcome this, we can use the effective annual rate which creates a more accurate picture of the true cost. We’re going to consider an investment with a nominal rate of 5% and demonstrate how the effective annual rate varies for differing compounding periods. For an investment that pays a nominal rate of 5% and is compounded only once per year we can deduce the effective annual rate using the EFFECT function.
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Calculate Effective Rate: (1:00)
How EFFECT works: (1:45)