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Effective interest rate

Nishad (student) (52 Points)

27 December 2013

What is effective rate of interest and how to calculate

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VIKASH GUPTA (COMPANY SECRETARY) (43 Points)
Replied 27 December 2013

In what reference you would like to calculate effective rate of interest??? Give some more informations...!

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Nishad (student) (52 Points)
Replied 27 December 2013

Sir,

Suppose I have deposited 125000 with Nationalised bank with 9.00% rate per annum but i m getting more than that ie 11670 how this amount comes

Rahul Gogate (Chartered Accountant) (213 Points)
Replied 27 December 2013

The concept of effective rate of interest is used when the rate of interest is stated as certain percent per annum, but is compounded at a shorter interval, like semi-annually or quarterly or monthly etc.

for example, Rs. 100 is invested for 2 years at 10% p.a. compunded semi-annually.

Thus, the intrerest comes to Rs. 21.55 rather than Rs.21 if it was compunded annually,

Thus, effective rate of interest becomes 10.25% when interest is compounded semi-annually.

effective rate= (1+r/k) the whole raised to power k minus 1

where, r= stated rate of interest

k is the no. of times interest is compounded in a year.

here, in the above example, effective rate woulod become [1+(0.1 divided by 2)]raised to two -1

that is, 1.05 raised to two is 1.1025, from which when one is subtracted, we get 0.1025, i.e. 10.25%

Nishad (student) (52 Points)
Replied 27 December 2013

Got cleared my concept thanks both of you

Subhash (None) (122 Points)
Replied 27 December 2013

Hello, Generally Banks pay you not at the nominal interest rate, but at the effective interest rate. Effective interest rate largely varies with n= number of times interest is calculated per year. Generally Indian banks calculate interest 4 times a year i.e.., quarterly. For the first quarter, your interest stays the same at 9% but from the second quarter, you'll be earning interest on interest and hence the effective rate. Effective rate of interest = {[1+(r/n)]^n}-1 I hope you understood the above equation. r= nominal rate of interest = 9% = 0.09 n= number of compounds per year =4 Eff.rate of int = {[1+(0.09/4)]^4}-1 Solving gives, Eff.rate of int = 9.308% 9.308%of1,25,000=11,635. If I reverse calculate as per your 11,670, n comes to 5. But no one compounds interest 5 times per year. Generally n can be 2, 4, 6, 12. Regards, Subhash.

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nidhi (ca) (24 Points)
Replied 09 September 2014

plz explain effective rate v/s nominal rate with a example???

Rahul Gogate (Chartered Accountant) (213 Points)
Replied 09 September 2014

nominal rate of interest refers to two distinct concepts- one is rate of interest without taking inflation into account and the second one is interest rate as stated, without adjustment for the full effect of compounding. I assume you have taken the second meaning.

When it is said Rs. 100 are invested @ 10% per annum compounded half-yearly, this 10% p.a. is nominal rate of interest.

actually the amount received after a year will be not Rs.110, but Rs. 110.25 as the amount is compounded half-yearly. So, in effect you got an interest of Rs. 10.25. So, the effective rate of interest becomes 10.25%

Rahul Gogate (Chartered Accountant) (213 Points)
Replied 09 September 2014

Originally posted by : nidhi
	plz explain effective rate v/s nominal rate with a example???

ominal rate of interest refers to two distinct concepts- one is rate of interest without taking inflation into account and the second one is interest rate as stated, without adjustment for the full effect of compounding. I assume you have taken the second meaning. When it is said Rs. 100 are invested @ 10% per annum compounded half-yearly, this 10% p.a. is nominal rate of interest. actually the amount received after a year will be not Rs.110, but Rs. 110.25 as the amount is compounded half-yearly. So, in effect you got an interest of Rs. 10.25. So, the effective rate of interest becomes 10.25%

Yasaswi Gomes new (Finance ) (4487 Points)
Replied 14 March 2024

Hey Subhash Did anyone notice that financial world is a fraud governed by frauds. No text book mentions why effective interest rate is choosen but it just says generally banks accept bribes and fixed deposits etc