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
generic name of the form used to file taxes payable to a federal, state, or local government. The tax return includes items such as gross income, deductions, tax credits, and tax due. ...
The rate at which a market can absorb additional units of supply without causing market saturation and severe price distortions. For example, during a recessionary period, many homeowners ...
(1) Method of measurement lumber using the board foot cubic measure. The board measure is used to estimate quantities and prices of lumber materials. (2) Method of estimating lumber ...
See ordinary annuity. ...
The meaning of direct costs implies such expenses that you can connect straight to a particular goods’ or service’s production, manufacturing, and preparation. As opposed to ...
Same as term graduated lease: A rental stipulation a varying rental rate. Rental rate are determined tied to periodic appraisals or an inflation or an inflation index. The provision is more ...
As a collective noun, land cost means the total cost of purchasing a parcel of land or lot with specific land use and ownership. The land cost includes the purchase price, closing costs, ...
Amount paid to a person or business for bringing the parties together in a business arrangement. The finder may also act in a consulting capacity. The fee may be a flat amount or rate, a ...
Maybe you’re studying for your real estate exam, or you heard the word from your real estate agent and didn’t know what it means. Whichever your reason, we’ll go ahead and ...
Have a question or comment?
We're here to help.