Effective Interest Rate
The term effective interest rate is the actual return from a savings account or any investment where you pay interest when considering the effects of compounding costs over time. Through an effective interest rate, you can fully and correctly determine the real percentage rate that you own on a loan’s interest, a credit card, or any other debt type.
An effective interest rate is also referred to as an effective annual interest rate, the annual equivalent rate, or the effective rate.
The Effective Interest Rate Formula:
With:
i = Nominal Interest Rate
n = Number of periods
What does the Effective Interest Rate Mean?
When you look at loans, the way through which they are advertised will give you two types of information. Firstly, we’ll have the nominal interest rate, which doesn’t consider the effects compounding interest or fees have on the financial product. Secondly, and the one we focus on now, the effective interest rate, which gives you the real return paid on savings of the actual cost of a loan because it does take into account the effect fees and compounding interest have on the financial product.
For that exact reason, knowing and understanding what the effective interest rate means is important. Through a proper understanding of the effective interest rate, you can compare offers more accurately to make an informed decision based on the result.
How to Find the Effective Interest Rate?
To adequately explain how to find the effective interest rate from any financial product’s promotional information, we will look at two examples. Firstly, we’ll have Loan A that has a 5% interest rate that’s compounded monthly. Secondly, we’ll have Loan B with a 5.1% interest rate that’s compounded bi-annually.
Both of these loans are advertised with their nominal interest rate. Remember, this is the one that doesn’t take into account the effects fees and compounding interest has on the loan. To calculate the effective interest rate, we’ll use the formula shown above.
While the nominal interest rate for Loan A is smaller than that of Loan B’s, the effective interest rate from Loan B is lower than that of Loan A’s. This occurs because Loan B has fewer compounding times over the course of a year.
Popular Real Estate Terms
An asset. The term cost is often used when referring to the valuation of acquired property. When it is used in this sense, a cost is an asset. Concepts of cost and expense are often ...
Surveying the land to determine its suitability for a specific purpose, such as building a high-rise apartment house. ...
Mortgage guaranteed up to 30 years by the Veterans Administration to veterans meeting minimum requirements. Originally established by the Servicemen's Readjustment Act of 1944, amended ...
A portion of a real estate company's assets financed with debt instead of equity. It involves interest an principal obligations. Financial leverage is beneficial to real estate investors ...
Tax term describing current and necessary business expenses. Ordinary and necessary business expenses do not include long-term capital losses. For example, the XYZ stationary store deducts ...
A certificate of ownership in a real estate company. Pledged assets for a borrowing. An example is an office building serving as collateral for the mortgage. Way of protecting property ...
A cooperating broker or agent defines a real estate broker who helps another broker in a private property transaction. Typically, the cooperating broker represents the seller and is ...
Document describing the benefits and provisions for people or businesses covered by group insurance. Document in life and health insurance issued to a member of a group insurance plan ...
Across the globe, countries have comprehensive antitrust laws that protect customers and ensure the orderly conduct of businesses. Through antitrust laws, the playing field is balanced for ...
Have a question or comment?
We're here to help.