Question

If the interest is compounded more than once per year, which rate is higher, the stated rate or the effective rate? Choose the correct answer below. a. There is not enough information to decide. b. The effective rate and the stated rate are the same. c. The effective rate is higher. d. The stated rate is higher.

Answer 1

Answer:

c. The effective rate is higher.

Explanation:

The stated rate does not take into account compounding within the year, while the effective rate does. If interest is compounded once a year, both rates are the same, but if interest is compounded more than once per year, then the effective rate is higher than the stated rate.

For example, a stated rate of 10% compounded semiannually has an effective rate of:

$E = (1+\frac{0.10}{2})^2 -1\\E=10.25\%$