Effective Interest Rate

Accounting Dictionary

Effective Interest Rate

The effective interest rate is the rate you actually earn on an investment which may be different than the amount that is printed on the bond.

Even though two investments may have exactly the same rate, the more often the interested is compounded the more interest you will earn. If one investment is compounded yearly and the other investment is compounded monthly, you will earn more with the investment compounded monthly. The formula to compute effective interest is [(1 + interest rate/number of compounding periods) squared -1]. A Company issued $10,000 bonds paying 5% interest or $500 a year. Joan bought the bond for $5000. Since Joan receives $500 in interest every year, but she only paid $5000 for the bond, her effective interest rate is 10% ($500/$5000).

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