Chartered Institute of Stockbrokers (CISI) Professional Practice Exam

What is the effective annual rate of interest?

1. The nominal rate of interest

2. The rate of interest adjusted for inflation

3. The rate of interest you actually pay on the loan, regardless of its duration

4. The rate determined by the central bank

The correct answer is: The rate of interest you actually pay on the loan, regardless of its duration

The effective annual rate of interest (EAR) reflects the true cost of borrowing over a year, taking into account the effects of compounding interest. This rate differs from the nominal rate, which does not consider how often interest is applied. By incorporating the timing of interest payments, the EAR provides a more accurate representation of the actual financial impact on the borrower. This means that the effective annual rate is not merely a theoretical concept but a practical measure that shows the total interest paid on a loan or earned on an investment, recognizing that interest can accrue on previously accrued interest. Therefore, it captures the real economic cost of borrowing more effectively than other rates, which might omit such considerations. In contrast, the other options do not accurately describe the concept of effective annual rate. The nominal rate refers to the stated interest rate without adjustment for compounding and does not reflect the actual amount paid. The explanation regarding inflation adjusts the rate to reflect purchasing power but does not pertain directly to the concept of effective annual rate. Lastly, while central bank rates can influence broader interest rate environments, they do not define the effective annual rate, which is specific to the terms of a loan or investment.