Stated vs. Effective Annual Rate
The stated annual return is the annual return that an account or investment generates in one year, or the interest charged on a loan, without taking the effect of compound interest into account. This number, such as 10%, is given in the account information.
The effective annual return, on the other hand, accounts for intra-year compounding to give a more complete picture of how interest is generated in that account. This rate is more likely to have a decimal or fraction as part of it, such as 10.47%, due to compounding interest.
The effective annual return is a key tool for evaluating the true return on an investment or the true interest rate on a loan. The effective annual return is often used for figuring out the best financial strategies for people or organizations.
Key Takeaways
- Annual return is the interest paid on an account, investment, or loan.
- The stated annual return does not take intra-year compound interest into account, while the effective annual return does.
- The stated annual return on an account is a lower whole number, while the effective annual return is higher, such as 10% and 10.47%.
- Banks show whichever rate appears more favorable, according to the financial product they’re selling.
Which One Gets Used?
Which interest rate gets quotes generally depends on whether the consumer is paying the interest or the bank is.
When banks charge interest, the stated interest rate is used instead of the effective annual interest rate to make consumers believe that they are paying a lower interest rate. For a loan at a stated interest rate of 30%, compounded monthly, the effective annual interest rate would be 34.48%. In such scenarios, banks will typically advertise the stated interest rate instead of the effective interest rate.
For the interest a bank or brokerage pays on an account or investment, however, the effective annual rate is advertised because it looks more attractive. For a deposit at a stated rate of 10% compounded monthly, the effective annual interest rate would be 10.47%. Banks will advertise the effective annual interest rate of 10.47% rather than the stated interest rate of 10%.
Essentially, the bank, lender, or brokerage will show the rate that appears to be more favorable to the consumer.
Example
Suppose the stated annual interest rate on a savings account is 10%, and you put $1,000 into this savings account. After one year, you would expect your money to grow to $1,100.
But if the account has a quarterly compounding feature, your effective rate of return will be higher than 10%. After the first quarter or the first three months, your savings would grow to $1,025. Then, in the second quarter, the effect of compounding would become apparent. You would receive another $25 in interest on the original $1,000, but you would also receive an additional $0.63 from the $25 that was paid after the first quarter.
In other words, the interest earned in each quarter will increase the interest earned in subsequent quarters. By the end of the year, the power of quarterly compounding would give you a total of $1,103.80. So, although the stated annual interest rate is 10%, because of quarterly compounding, the effective rate of return is 10.38%.
That difference of 0.38% may appear insignificant, but it can be huge when you’re dealing with large numbers: 0.38% of $100,000 is $380.
Important
Compound interest will have a big impact on accounts that are open over a long period of time. For loans such as student loans or a mortgage, or investments such as a retirement account, the effect of compounding will be significant, even if the initial amount is $1,000 instead of $100,000.
Another thing to consider is that compounding does not necessarily occur only four times a year, as it does in the example above. Many accounts compound monthly; some even compound daily. And, as our example shows, the frequency with which interest is paid will have an impact on the effective rate of return.
What Is Simple Interest vs. Compound Interest?
Simple interest is paid only on the amount of the principal invested in an account, not on the interest earned by the account. Compound interest is paid on both the principal and the interest earned.
How Often Does Compounding Interest Happen?
How often interest is compounded on an account varies. Accounts may offer annual, semiannual, quarterly, monthly, weekly, or daily compounding. The terms of your account should outline how often interest is compounded.
What Is the Rule of 72?
The rule of 72 states that the time it will take an investment or account to double is 72 divided by the interest rate. For example, if an account offers 5% interest with compounding, the initial investment will take about 14 years and 5 months to double.
The Bottom Line
The annual return is the interest paid on an account, investment, or loan. This can be paid either by the institution or the consumer, depending on the type of account. Annual return can be expressed two ways: stated annual return or effective annual return. The stated annual return does not take compound interest into account, while the effective annual return does.
Banks and lenders will advertise whichever rate looks more favorable to the consumer. Stated annual return is often used on loan accounts because it is a lower number. Effective annual rate, on the other hand, is higher because of the effects of compounding. It is generally advertised on deposit or investment accounts to attract consumers.
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