The effective annual interest rate is one of the most important concepts in personal finance. It is the rate at which an investment or loan will actually earn (or cost) money in a given year. It is also known as the annual equivalent rate or the effective interest rate.

The effective annual interest rate is different from the nominal interest rate, which is the amount of interest that is advertised and charged or paid on a loan or investment. The interest rate is usually calculated on a yearly basis, even if payments are made or received more or less frequently during the year. The effective rate takes into account any compounding, or the growth of the investment due to reinvestment of the interest paid out over the course of the year.

When looking at two different rates that involve compounding, the effective rate should be compared. This will allow investors and borrowers to truly understand the amount of money they will make (or pay) over the course of one year. It is also important to note that the more frequent the payments, the greater the advantage the bank or lender may have, and the higher the effective rate will be.

For example, a loan may have an 8% nominal interest rate but if it compounds monthly instead of quarterly payments, then the effective rate is 8.20%. Over the course of one year, the extra 0.2% of interest compounding each month adds up to earning more money over the course of the year.

When looking for a loan or investment, it is important to take into account the effective annual interest rate as well as other factors such as fees and terms. Comparing effective rates between different loans or investments will help you to determine which one is a better financial decision. The effective annual interest rate should also be considered when calculating how long it will take to pay off a loan or make a desired return on an investment.