What is Effective Interest Rate?
The effective interest rate (EIR), also called the annual equivalent rate, is the rate that reflects the true annual cost of a loan or yield on an investment after adjusting for compounding frequency and certain fees. It allows fair comparison between financial products that quote different nominal rates and compounding periods.
How It Works
- EIR = (1 + nominal rate / m)^m – 1, where m is the number of compounding periods per year.
- For continuous compounding, EIR = e^(nominal rate) – 1.
- Under IFRS 9, financial assets and liabilities are measured at amortized cost using the EIR method.
- EIR includes transaction costs and fees, distinguishing it from the simple nominal rate.
- Higher compounding frequency increases the gap between EIR and nominal rate.
Saudi Context
SOCPA-aligned IFRS 9 requires Saudi banks, finance companies, and corporates to amortize bond and sukuk discounts, premiums, and transaction costs using the effective interest rate method. SAMA-regulated consumer finance products must disclose the APR (effective rate) to retail customers under the consumer protection rules.
Example
A SAR 100,000 bond is issued at SAR 96,000 with a 5% annual coupon and matures in 5 years. The effective interest rate (yield to maturity) is approximately 5.95%. The issuer recognizes interest expense at 5.95% on the carrying amount each year, not 5%, gradually accreting the discount.