What is effective interest rate?

Effective interest rate (EIR) is the actual rate of interest earned or paid on a loan or investment over a specific period, taking into account compounding and other associated charges. Unlike the nominal interest rate, which is the rate quoted by lenders or investors, the effective interest rate is the actual rate paid or earned.

The nominal rate does not take into account the impact of compounding and other fees, while the effective interest rate considers all associated costs and calculates the true cost or return.

Suppose you borrow $10,000 for one year at a nominal interest rate of 8% per annum, compounded monthly. Are you in a position to know if your bank, SACCO, or any financial institution is robbing you?

EIR = (1 + (0.08/12))^12 - 1
EIR = 0.0833 or 8.33%

Based on the example above, the effective interest rate on the loan is 8.33%, which is higher than the nominal rate of 8% due to the effect of compounding.

Calculate your effective interest rate