CISI Professional Practice Exam 2026 – Complete Prep Guide

The effective annual interest rate is calculated by taking the nominal interest rate and adjusting it based on the frequency of compounding within a year. This means that if interest is compounded more frequently than annually, you must account for this additional growth by dividing the nominal rate by the number of compounding periods per year. Then, you compound that result over the number of periods to find the equivalent rate that reflects the true cost of borrowing or the true yield on an investment over a year.

This approach captures the effects of compounding, which can significantly increase the total interest earned or owed compared to simply using the nominal rate. Therefore, calculating the effective annual interest rate in this manner provides a more accurate picture of the interest being charged or earned over time, accounting for how often interest is applied to the principal.