Stated Annual Return vs. Effective Annual Return: An Overview
- Stated annual return does not take into account the effect of intra-year compound interest.
- Effective annual return accounts for intra-year compounding of interest,
- Banks show whichever rate appears more favorable, according to the financial product they're selling.
Stated Annual Return
The stated annual return is the simple annual return that a bank gives you on a loan. This interest rate does not take the effect of compound interest into account.
Effective Annual Return
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.
The difference between these two measures is best illustrated by an 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, 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 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. 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 shows, the frequency with which interest is paid will have an impact on the effective rate of return.
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 example, 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 pays on a deposit account, the effective annual rate is advertised because it looks more attractive. For example, 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, they show the rate that appears to be more favorable.