What is the effective interest rate?

Definition of Effective Interest Rate

The effective interest rate is the true rate of interest earned. It can also mean the market interest rate, the yield to maturity, the discount rate, the internal rate of return, the annual percentage rate (APR), and the targeted or required interest rate.

Example of the Effective Interest Rate

Assume that a corporation issues a $1,000 bond with a stated, contractual, face, or nominal interest rate of 5%. This means that the corporation will pay exactly $50 per year during the life of the bond plus the principal amount at maturity. Let's also assume that after the bonds are issued the market interest rates increase by one percentage point. As a result the 5% bond will lose some of its value because the contractual payment of $50 per year is not worth $1,000 when the market is paying $60 per year for a similar $1,000 bond. An investor will purchase the 5% bond only if the cost is low enough to yield 6% over the remaining life of the bond. In other words, the investor will pay less than the $1,000 so that the effective interest rate for the remaining life of the bond will be 6%.