Nominal Interest Rate: Interest rate quoted based on an annual period.

Effective Interest Rate: Actual interest earned or paid in a year or some other time period.

Given the nominal interest rate per year, r, and the number of interest periods per year, m, the effective annual interest rate, i_a, can be computed as follows:

ia = (1 + r/M)M - 1

Example 1  Nominal annual interest rate is listed at 10.0% and the loan is compounded monthly.  Determine the Effective Annual Interest rate.

ia = (1 + .10/12)12 - 1

 = 10.4713067%

The use of the word "effective" is not intuitively clear. This term is used for rates of interest in which interest is paid once per measurement period. This will be contrasted with "nominal" rates of interest, in which interest is paid more frequently than once per measurement period.

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