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
A window in a roof or ceiling of a structure from which light enters the house. ...
To put it simply, acquisitions are a common occurrence in the business world, and they happen to small, medium, and large businesses alike. The definition of acquisition is a company ...
Federal agency that aids veterans of the armed forces. For example, it guarantees a home loan for up to a predetermined dollar amount or percentage of the loan balance, whichever is less. ...
A roof forming a triangle from the eaves to the ridge of the roof. ...
Generally speaking, indemnity defines a legal principle and an ensuing agreement to calculate the amount of compensation a party is entitled to resulting from a specific financial loss they ...
The return by owners of a property investment usually through a depreciation allowance. a clause in a contract permitting the prior owner of real estate to recover under certain ...
Restraining a person or business from denying an appropriate conveyance of property evidenced by a deed has given. ...
Corporation having only one person, A corporation sole is primarily used for the purposes of a nonprofit ecclesiastic church related organization. Ina church, the corporation sole is headed ...
The add-on interest is a type of interest that is figured into the total cost of a loan over its entire life. The interest is added to the principal and divided by the number of monthly ...
Have a question or comment?
We're here to help.