The rate of interest that uses compounding in the calculation. It is the annual rate of return that is actually earned or charged during the period the funds are held or borrowed. The effective rate of interest (effective interest rate, IR) can be calculated with the following formula:

Effective IR = amount of interest earned during the year/ amount of money invested or deposited

It is typically used to determine the amount of interest to be credited to an account. For amounts invested during an entire year, the annual effective rate of interest multiplied by the principal will equal the amount of interest earned. For example, a deposit of $1,000 may have a stated interest rate of 6%. If it is held for one year, the effective rate of interest will be:

Effective rate of interest = (6% × 1,000)/ 1,000 = 6%

Here, the effective rate of interest is equal to the stated interest rate (because there is no compounding). However, if interest is applied to deposited funds at midyear, i.e., it is compounded semiannually, the total interest earned for the year, will be higher. The amount of interest earned during the year is:

Total interest earned = interest earned in first 6-months + interest earned in second 6-months

Interest earned in first 6-months = (1,000 × 0.06 × 6/12) = $30

Interest earned in second 6-months = (1,000 + 30) × 0.06 × 6/12 = $30.9

Total interest earned = 30 + 30.9 = $60.9

In the second half of the year, interest is applied to a larger investment (i.e., interest earned in the first half is added to the principal amount. In this case, interest earns interest).