How to Calculate Effective Interest Rate-
When analyzing a loan or an investment, it can be difficult to get a clear picture of the loan's true cost or the investment's true yield. There are several different terms used to describe the interest rate on a loan, including annual percentage yield, annual percentage rate, effective rate, nominal rate, and more. In all of these, the effective interest rate is the most useful, it shows a relatively complete picture of the true cost of borrowing. To calculate the effective interest rate on a loan, you will need to understand the loan's specified terms & conditions and perform a simple calculation.
What is an effective interest rate?
The effective interest rate is the actual return on a savings account or any other interest-paying investment when the effects of compounding over time are taken into account. It also reveals the actual percentage rate owed as an interest on a loan, a credit card, or any other debt.
The effective interest rate is also called the effective rate or the annual equivalent rate.
How do you calculate effective interest rate?
The effective interest rate is calculated by using a simple formula
Effective Annual Interest Rate=(1+ni)n−1
where:
i=Nominal interest rate
n=Number of periods
What does Effective Interest Rate tell you?
Most of the bank's certificate of deposit, saving account or a loan offer may offer with its nominal interest rate as well as its effective annual interest rate. The nominal interest rate does not reflect the effects of compounding interest. The effective annual interest rate is the actual return. Interest may be both simple or compounding. Basically, Simple interest is based on the principal amount of a loan or deposit and compound interest is based on the principal amount and the interest that accumulates on it in every period.
Whenever we say 10% compounded quarterly it means interest is applied quarterly @ 2.5% to the principal amount in the first quarter and 2.5% to the principal and the interest applied during the first quarter. So, at the end of the year if you divide the total interest amount by the principal amount then it will not be 10% but somewhat higher. This higher rate of interest is called the effective interest rate.
For example,
Consider a loan with an interest rate of 5 percent that is compounded monthly.
Using the formula: r = (1 + .05/12)12 - 1,
r = 5.12 percent.
Effective rate of interest will be 5.12%
The same loan compounded daily would yield
r = (1 + .05/365)365 - 1,
r = 5.13 percent
Effective rate of interest will be 5.13%
A home loan at 9% is only a nominal rate of interest. The effective interest will be calculated monthly
r= (1+.09/12)12-1
r=9.38
Effective rate of interest will be 9.38%
The effective interest rate will always be greater than the specified rate.
That's why an effective annual interest rate is an important financial concept to understand. Whether its about how to get a car without credit, emergency loan or student loan, You can compare various offers accurately only if you know the effective annual interest rates of each.
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