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
Unfortunately, we encounter false advertising daily. False advertising refers to deceptive or misleading ads and commercials that fail to showcase a product’s or service’s ...
Impeding and restricting people in various activities based on their race, ethnic reasons, or religion now goes against US laws in effect. In the past, especially in the 1960s, ...
The construction of stone or block walls without using concrete or mortar. Drywall construction is a traditional building technique used for stone field wall construction. Newer building ...
Real estate sales contract where possession and use is provided to the buyer, but the deed is kept by the seller until the full purchase price is met whereupon the title is placed in the ...
A corporation that owns housing units and whose tenants purchase shares in the corporation equivalent to the value of their housing unit. Also called co-ops. ...
A lien on the property of a mortgagor. In most states a mortgage gives the mortgagee a lien-as opposed to the common-law practice of granting conditional title-on the house or property as ...
To confirm, ratify, verify, and accept a transaction that can be canceled. ...
Linkage of property ownership that connects the present owner to the original source of title. ...
Home inspector is the name the real estate industry calls the professional responsible for the close and thorough examination of a property. The home inspector usually is called upon ...
Have a question or comment?
We're here to help.