A:

Essentially, the effective annual return accounts for intra-year compounding, and the stated annual return does not.

The difference between these two measures is best illustrated with an example. Suppose the stated annual interest rate on a savings account is 10%, and say you put $1,000 into this savings account. After one year, your money would 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 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! Another thing to consider is that compounding does not necessarily occur quarterly, or only four times a year, as it does in the example above. There are accounts that compound monthly, and even some that compound daily. And, as our example showed, the frequency with which interest is paid will have an effect on effective rate of return.

(To read more, see Projected Returns: Honing The Craft.)

RELATED FAQS
  1. How does the compound interest concept vary between a basic savings account and an ...

    I understand compound interest as it relates to a basic savings account. If you get 5% interest on $1000 each year, it will ... Read Answer >>
  2. Other than my savings account, what other types of holdings compound my interest?

    Understand the benefits of compounding interest, and learn the types of investments that offer compounding in addition to ... Read Answer >>
  3. What formula can I use to calculate interest on interest?

    Find out more about compounding interest, what it measures and how to calculate the amount of compound interest accrued using ... Read Answer >>
  4. How often is interest compounded?

    Understand what compound interest is and how the compounding of interest applies to the benefit of investors or creditors, ... Read Answer >>
  5. How do mutual funds compound interest?

    Learn how mutual funds can grow wealth over time through the magic of compound interest by reinvesting dividends back into ... Read Answer >>
  6. What is continuously compounding interest?

    Read a quick explanation of continuously compounding interest rates, why compounding matters and how to calculate the continuous ... Read Answer >>
Related Articles
  1. Bonds & Fixed Income

    Accelerating Returns With Continuous Compounding

    Investopedia explains the natural log and exponential functions used to calculate this value.
  2. Investing

    The Effective Annual Interest Rate

    The effective annual interest rate is a way of restating the annual interest rate so that it takes into account the effects of compounding.
  3. Investing

    How does Compound Interest Work?

    A quick way to understand the impact of compound interest is to ask yourself if you’d rather receive $100,000 a day for a month, or start with a penny on day one and double it every day for those ...
  4. Savings

    How Interest Rates Work on Savings Accounts

    Here's what you need to know to grow your rainy-day fund.
  5. Investing Basics

    Learn Simple And Compound Interest

    Interest is defined as the cost of borrowing money, and depending on how it is calculated, can be classified as simple interest or compound interest.
  6. Investing Basics

    APR and APY: Why Your Bank Hopes You Can't Tell The Difference

    Banks use these rates to entice borrowers and investors. Find out what you're really getting.
  7. Fundamental Analysis

    How To Calculate Your Investment Return

    How much are your investments actually returning? Find out why the method of calculation matters.
  8. Investing Basics

    Understanding Compound Interest

    Compound interest is often called one of the most powerful concepts in finance. Find out what it is and how it can work for you.
  9. Forex

    Compound Annual Growth Rate (CAGR)

    The compound annual growth rate is an important tool for measuring investment performance and comparing it across asset classes. Discover how it is calculated and how it can inform your investment ...
  10. Retirement

    What Your 401(k) Can Look Like in the Next 20 Years

    Discover how time and compounded growth of earnings can help even a modest 401(k) plan balance grow to a significant sum over a period of 20 years.
RELATED TERMS
  1. Stated Annual Interest Rate

    The return on an investment that is expressed as a per-year percentage, ...
  2. Effective Annual Interest Rate

    Effective Annual Interest Rate is an investment's annual rate ...
  3. Compound Return

    The rate of return, usually expressed as a percentage, that represents ...
  4. Compound Interest

    Compound Interest is interest calculated on the initial principal ...
  5. Discrete Compounding

    Discrete compounding refers to the method by which interest is ...
  6. Periodic Interest Rate

    The interest rate charged on a loan or realized on an investment ...
Hot Definitions
  1. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  2. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  3. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  4. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  5. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  6. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
Trading Center