Effective Interest Rate

Yield on a Debt Instrument as calculated from the purchase price. The effective rate on a bond is determined by the price paid for the security, the coupon rate, the time between interest payments, and the time until maturity. The effective rate is a more meaningful yield figure than the Face Interest Rate or the coupon rate. See also Rate of Return; Yield to Maturity.

The true rate of return considering all relevant Financing expenses. See Annual Percentage Rate.
Example: Abel borrows $10,000 on a one-year bank loan. He pays 2 Discount Points and a 7% Face Interest Rate. He repays the loan at the end of the year, with interest. Since he really received only $9,800 at the start of the loan and repaid $10,700, the effective rate was greater than 7%. It was approximately 9.2%.

1. Yield to Maturity.

2. Real rate of interest on a loan equal to the nominal interest divided by the proceeds of the loan. Assume a company took out a $10,000, one-year, 10% discounted loan. Discounted loan refers to interest being deducted immediately in arriving at proceeds. This effectively raises the cost of the loan. Further, assume a Compensating Balance requirement of 5%. The effective interest rate equals: