THE GLOSSARY · RATES
Effective annual rate
Two loans both show 19.99%. One costs 19.99%, the other 22.12%. The difference is one word nobody reads: compounding.
By the Yoseri News desk · · 1 min read
Effective annual rate — what a rate really costs over a year, once you count the interest that is added to the principal along the way. Not to be confused with the nominal rate, the one on display.
The nominal rate says nothing until you know how often it compounds. At 19.99% nominal:
| Compounding | Effective rate |
|---|---|
| Annual | 19.99% |
| Monthly | 21.93% |
| Daily | 22.12% |
The calculation is one formula: (1 + rate ÷ n)n − 1, where n is the number of compounding periods a year. For daily: (1 + 0.1999 ÷ 365)365 − 1 = 22.12%.
The gap is 2.13 points — on a $3,000 balance carried for a year, $64 the advertised rate did not let you see.
Most credit cards compound daily. Most Canadian mortgages compound semi-annually, which goes the other way: an advertised mortgage rate costs a little less than the same rate compounded monthly.
Yoseri News is an educational publication. Nothing in this article is investment advice, a recommendation to buy or sell, or tax advice. Yoseri is registered as neither an adviser nor a dealer with any market authority.