Question

What is the effective interest rate of 8%p.a. nominal interest rate when compounded monthly? Ans : 8.30% Pls attach the formula used, and explain in detail. Pls do not answer in excel format. Thank you in advance.

Answer 1

Effective interest rate = (1 + APR/n)ⁿ - 1

Effective interest rate = (1 + 0.08/12)¹² - 1

Effective interest rate = (1 + 0.00667)¹² - 1

Effective interest rate = (1.00667)¹² - 1

Effective interest rate = 1.0830 - 1

Effective interest rate = 0.0830 or 8.30%

As the frequency of compounding increases, the effective interest rate is greater. Here, interest on interest is getting added every month. Therefore, effective rate of 8% compounded monthly will always be greater than 8% compounded annually.