Effective interest rate

The effective interest rate (EIR), effective annual interest rate, annual equivalent rate (AER) or simply effective rate is the percentage of interest on a loan or financial product if compound interest accumulates over a year during which no payments are made. It is the compound interest payable annually in arrears, based on the nominal interest rate. It is used to compare the interest rates between loans with different compounding periods.

Depending on the jurisdictional definition, the effective interest rate may be higher than the annual percentage rate (APR), since the APR method reflects the annual total interest charge assuming periodic interest is paid as soon as it accrues and does not take compounding into account. By contrast, the EIR annualizes the periodic rate with compounding by computing the effects of compounding assuming no periodic payment of interest, so that future interest accrues on both the principal and the current interest. EIR is the standard in the European Union and many other countries, while APR is often used in the United States.

Annual percentage yield or effective annual yield is the analogous concept for savings or investments, such as a certificate of deposit. Since a loan by a borrower is an investment for the lender, both terms can apply to the same transaction, depending on the point of view. For a zero-coupon bond such as a US treasury bill, an annual effective discount rate may be specified instead of an effective interest rate, because zero coupon bonds trade at a discount from their face values.