Interest rate is generally expressed yearly that means if for example rate of interest on loan of $10000 is 12 percent then it would imply that interest on loan would be $1200. However in some transactions interest is payable quarterly or monthly and that is where effective annual interest rate comes into play.
Effective annual interest rate is the rate which takes into account the effect of compounding, which is when the interest has to be paid more than 1 time in a year. It can be calculated by the following formula
(1+ I/n) n – 1
Where I – Interest rate
N – Number of times interest has to be paid in a year
Now suppose the interval for payment of interest is quarterly or 4 times in a year and interest rate is 12 percent then putting the figures in above formula (I is .12 and N is 4) effective annual interest rate will be 12.55 percent and not 12 percent.