Effective Interest Rate
The nominal annual interest rate is the stated annual rate charged by the lender and the effective annual rate is the true annual interest rate at which interest is actually paid.
Effective annual rate reflects the effect of compounding frequency. The effective rate of a loan or an investment will always be higher than the nominal or stated interest rate when interest is compounded more than once per year. The formula is as follows.
Effective Interest Rate = (1 + (i / n))n – 1
Where:
i = nominal or stated interest rate
n = number of compounding periods per year
For example, if the interest rate is 8%, and if this is compounded semiannually, the
Effective Rate = (1 + (0.08 / 2))2 – 1 = 0.0816 or 8.16%
Although this seems like a small difference of 0.16% at first glance, if we use credit card finance charges as an example, then the difference is quite significant. Credit card debts in my country carries a nominal interest rate of 18% per year and card companies divide it by 12 to show 1.5% per month. The finance charges are calculated either based on monthly rest or daily rest.
So effective interest rate calculated based on : -
- monthly rest( i.e. compounded 12 times a year), = (1+0.18/12))12 - 1 = 0.1956 or 19.56%, and
- daily rest( i.e. compounded 365 times a year), = (1+0.18/365))365 - 1 = 0.1972 or 19.72%.
If you don’t pay off the any balance you owe the credit card company, the money you owe will be double in just 3.6 years through the interest they charge you!!
Therefore before you think of easy financing or taking out any type of loan, calculated the effective interest rate before you sign on the dotted line. You could be paying much more than you think.
