Effective Rate of Return

Profitability ratios Print Email

The effective rate of return is the rate of interest on an investment annually when compounding occurs more than once.

It is calculated through the following formula:

Effective Rate Of Return = (1 + i/ n) n-1

Here; i stands for the annual interest rate

N stands for the number of compounding periods

It can be said that the Effective Rate Of Return determines the effect of compounding for the annual interest rate.

It can be better explained this way that if an investment pays 5 percent per year but without any compounding than the effective rate of return will be 5 percent. On the other hand, if an investment is compounded monthly then the effective rate of return will be greater than 5 percent.

If we move on to the importance of the effective rate of return then it is said to be important for 2 reasons. First one is that it is accurate. It is much more than estimating returns only. It helps in determining all the details that might be needed for compounding. Secondly, it is being popularly used as it is based on simple calculations of interests.

The effective rate of return helps to determine the return that will be gained on each investment and it covers up a number of marketing instruments, loans and investments.

It can be said that effective rate of return is useful in determining what amount of money will be gained or lost on an investment during a given course of time. The amount that can be lost or gained might be profit, net income, interest or loss. In this way, the financial analysts are able to calculate what amount of gain or loss they will be born over the amount of money that they have invested in a particular thing over a certain time period.  

Quote Guest, 25 February, 2015
I have tried to put the formula into an excel spreadsheet to calculate the monthly effective rate for an annual percent return.  I can get it to work for a positive rate of return but the spreadsheet gives the wrong answer for a negative rate of return.  Any idea what I could be doing wrong?
Quote Guest, 24 September, 2015
Try using the IRR (Internal Rate of Return) formula instead.

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