Certified Residential Appraiser Practice Exam

What is meant by effective interest rate?

1. Nominal interest rate multiplied by loan term

2. Interest per dollar per period

3. Rate considering taxes and other deductions

4. The annual rate minus inflation rate

The correct answer is: Interest per dollar per period

The effective interest rate refers to the actual interest earned or paid over a year, taking into account the effects of compounding. This term is often expressed as interest per dollar per period, meaning it shows how much interest is generated for each dollar over a specified time frame. This measurement is particularly important for understanding the true cost of borrowing or the actual return on an investment since it factors in the frequency of compounding, resulting in a more accurate reflection of interest rates in financial calculations. In contrast, other options may represent different financial concepts. The nominal interest rate multiplied by the loan term pertains more to the basic interest earned over time without considering compounding. A rate considering taxes and other deductions would refer to a net interest rate but does not define the effective interest rate. Lastly, the annual rate minus inflation rate describes the real interest rate, focusing on purchasing power rather than the actual compounding effect of interest payments.