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Effective Annual Interest Rate
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An effective annual interest rate is used to determine the interest rate on an annual basis after accounting for the effects of compounding. A 10% annual rate compounded yearly would imply a 10% effective annual interest rate. A 10% annual rate compounded monthly would imply a 10.47% effective annual interest rate. The effective annual interest rate can be used to compare different nominal rates with different compounding schedules. For example, Bank A offers 14.75% compounded semiannually. Bank B offers 14.50% compounded monthly. To determine the better return on investment, the effective annual interest rate for both should be calculated, taking into account the different compounding schedules. The effective annual interest rate for Bank A is 15.29%, whereas the effective annual interest rate for Bank B is 15.50%. Therefore, the rate offered by Bank B provides a better return on investment.
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