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To calculate the effective annual interest rate, you need to take into account the nominal interest rate and the number of compounding periods per year. The formula for effective annual interest rate is:
(1 + (nominal interest rate / number of compounding periods))^number of compounding periods – 1
For example, if the nominal interest rate is 5% and interest is compounded monthly, the effective annual interest rate would be:
(1 + (0.05 / 12))^12 – 1 = 5.116%
This means that if you were to invest $1,000 with a 5% nominal interest rate compounded monthly, you would earn $51.16 in interest over the course of one year.
The effects of interest rates are often not directly felt but play out over a long time as valuations of real-estate and other assets adjust.
At Horizon65, we created a mobile app that enabled you to check the effect of high interest rates on your savings and to simulate potential investments that can defend against it.