Effective annual rate is the rate of interest taken into account compounding over the year. For example, a bank offers 2 percent interest each month. The bank account is making over 2 percent over the course of a year due to compounding. By finding the effective annual rate of more than one investment, an investor may apply his money to the investment with the highest return.
Divide the annual interest rate by the number of periods compounding, then add one to the answer. In the example, 2 percent divided by 12 months, equals 0.001667, plus 1, which equals 1.001667.
Raise the number calculated in Step 1 to the power of the number of periods compounding. In the example, 1.001667 ^ 12, which equals 1.020814.
Subtract 1 from the number calculated in Step 2. In the example, 1 minus 1.020814 equals 0.020814.
Multiply the number calculated in Step 3 by 100 percent. In the example, 0.020814 times 100 percent equals an effective annual rate of 2.0814 percent.
Carter McBride started writing in 2007 with CMBA's IP section. He has written for Bureau of National Affairs, Inc and various websites. He received a CALI Award for The Actual Impact of MasterCard's Initial Public Offering in 2008. McBride is an attorney with a Juris Doctor from Case Western Reserve University and a Master of Science in accounting from the University of Connecticut.