What is Effective Interest Rate?

The term interest rate can be defined as the amount that is charged by the lender as a percentage on the principal amount. Interest rate which is charged annually is known as annual percentage rate.

Majority of the mortgages apply simple interest rate. However, there are some loans which consider compound interest. Loans which are subject to low risk have less interest rate & loans which are prone to high risks are subject to high rate of interest. Loans like consumer loans consider annual percentage rate and not a compound interest.

Annual percentage rate can be defined as an interest rate which is earned from a bank. On the other hand, savings account and certificate of deposit considers compound interest.

Interest rates are of different types and they are categorized as real rate, nominal rate and effective rate.

• Real rate: Real rate is an interest rate which considers economic conditions like inflation in order to give correct measure of buying power to the investors.
• Nominal interest rate: Nominal interest rate can be defined as the stated rate either on a bond or on a loan. This can be defined as the actual price which is paid by the borrower to the lender in order to avail the loan. Nominal rate is also known as coupon rate.
• The third type of interest rate is the effective rate which is discussed below:

Factors which Influence the Interest Rate

Some of the factors which influence the interest rate are demand and supply factors, economic conditions like inflation, global and foreign exchange rates and government policies.

Meaning of effective:

The term effective refers to success in achieving the required result. Hence effective always ensures in providing the required returns.

Meaning of nominal:

The term nominal refers to producing something at a value that is lower than the real value.

Definition of Effective Interest Rate

Effective interest rate or effective annual interest rate can be defined as the real return on a savings account or any other investment paying interest after considering the effects of compounding. Higher is the frequency of compounding, higher would be the return. Also known as effective interest rate or effective rate or annual equivalent rate is also an interest rate on a loan or a credit card or any other debt.

Formula for calculation of effective annual rate is:

Effective annual interest rate = (1+i/n)^n - 1

Where i is the nominal interest rate and n is the number of periods.

Apart from the above formula, there is also interest rate calculator to calculate the appropriate interest rate.

Effective interest rate calculation:

For example:

If there are two loans in which the stated interest rate is 20%. One loan is compounded annually and the other loan is compounded semi annually. Though both the loans have the same interest rate, one which is compounded semi annually will have higher effective interest rate.

Importance of Effective Interest Rate

Effective interest rate is vital for the following reasons:

For Borrowers: Without effective interest rate, borrowers would be misguided and true cost of the loan would not be revealed.

For investors: Effective rate is important for investors in order to forecast the actual expected return from an investment. Because of these investors cannot make correct investment decisions.

Following are some of the effective annual rates:

Credit card effective annual rate:

A credit card which has a balance of $2,000 and with an APR of 10% will have a interest of $200 in a year. Generally, interest on a credit card is compounded daily

Hence effective interest rate = [(1+10%/365) ^365 - 1] = 1.105156 - 1 

Hence effective interest rate = 0.105156 or 10.52%

Investment Effective Annual Rate

Effective annual rate on an investment is nothing but the rate which is paid to the investor. For example, if there are two investments with an annual interest rate of 5%. One investment is compounded monthly and the other is compounded half yearly.  First investment will provide the higher return because of its more frequent compounding.

Factors which influence the effective interest rate:

• Extra charges: Product or investment chosen by the investor may require him to pay some hidden fees. Addition of such fees may change the effective rate.
• Adjustment on the basis of market rate: If the market rate for a particular product is higher or less than the nominal rate of interest, then the borrower can either bid higher or less than the face value of the debt.

IRR

Internal rate of return is one of the popular metrics used in financial analysis in order to calculate the profitability of the investment. This rate is usually calculated on trial-and-error basis or by making the net present value as zero. Higher the IRR, more suitable is the investment.

Future Value

Future value can be defined as the value of a particular asset at a future date. Finding the future value of an asset is not an easy task and involves lot of challenges. Future value can be calculated using two ways one is by simple interest and the other is by compound interest.

Effective annual yield

Effective annual yield can be defined as a metric used for measuring the annual return on the investment after considering the effects of compounding.

Financial Modeling

Financial modeling involves the process of creating a summary about the earnings and expenses of a company in the form of a spreadsheet. This is one of the decision-making tools used by organization in order to estimate the cost and profits of a new project.

Personal loan

Personal loan is a type of loan borrowed for the personal use of the individual. Rate of interest charged on a personal loan will not be the same and it varies among financial institutions. Personal loans are used by individuals in order to meet their monthly requirements or for various other reasons.

Context and Applications    

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for  

• B.B.A. 
• M.B.A. 
• B. Com