Quick answerA 12% nominal annual rate compounded monthly is 1% per month, but its effective annual rate is about 12.6825% because interest compounds during the year.
Effective annual rate formula
EAR = (1 + j ÷ m)m − 1j is the nominal annual rate and m is the number of compounding periods per year.
Nominal and effective rates are not interchangeable
| Rate | What it describes | Typical use |
|---|---|---|
| Nominal annual rate | Quoted annual rate before within-year compounding | Loan or deposit rate stated with a compounding frequency |
| Periodic rate | Rate applied each period | Nominal annual rate divided by periods per year |
| Effective annual rate | Actual one-year growth from compounding | Comparing rates on an equivalent annual basis |
Example: 5% nominal compounded monthly
The monthly periodic rate is 5% ÷ 12 = 0.416667%. Applying that rate 12 times produces an effective annual rate of approximately 5.1162%.