# Effective Interest Rate Method: Secrets You Need to Know

## What Is an Interest Rate?

The simplest way to think of an interest rate is the amount that someone will charge you for borrowing a sum of money. So for instance if you borrow \$100 and they want it back with an extra \$10 then they have charged you 10% interest; or have they? There are actually many different ways to calculate and look at interest rates (as well as periodic payments) with regards the period over which you will take the loan and in comparison to the purchasing power of your money.

Within finance therefore, you have to be able to fully understand the many different ways that you could define interest rate such as the effective interest rate method. You also need to understand how and why those different methods exist and also how banks and other bodies use these different rates to their advantage.

## What Are the Different Types of Interest Rates That You Could Use?

Before we get into a more detailed discussion about the effective interest rate and its calculation you need to know what the other methods are and how and why they differ. The following are commonly used methods for calculating and stating an interest rate:

The nominal interest rate

This is the simplest form of interest rate to understand and is also known as the coupon rate as it normally stamped on the coupons that were then redeemed by bondholders. It is simply the amount that the borrower will pay the lender for the use of their money. So if the nominal rate is 5% and they borrow \$100 they will need to repay the total sum of \$105.

This is the simplest way to consider interest and it is how most people believe that any interest that they pay for a loan is calculated. However, generally there are other calculations used by the banks and other lending institutions.

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The real interest rate

The nominal interest rate makes no allowances to what is happening with the purchasing power of your money. Inflation will reduce the purchasing power of the interest that you are earning and as such the real amount of interest that you are earning may be much lower than you think as it is being reduced by the current interest rates.

For instance if you have a bond that has an interest rate of 7% but inflation is running at 4% then the real interest rate is just 3% after the effect of inflation has been factored into the equation. Of course if there is actually a period of deflation then this can work in your favor and actually improve the real return on an investment. The real interest rate is simply: Real Interest Rate = The Nominal Interest Rate – Inflation Rate

Effective interest rate

Defining the interest rate that is being paid also will depend on how you make your term definition and how often the interest is calculated. For instance if you add interest to the principle amount each month and then have to pay interest on that additional amount in the following month then the effective of the interest rate is compounded.

The effective interest rate therefore takes into account compounding. This will often be listed as the AER (Annual Equivalent Rate) and takes into account that each interest payment will be based on a slightly higher balance each time. The more compounding periods that you have then the greater the effect that this will have on the interest that you pay.

Annual percentage rate (APR)

Because of the many ways that an interest rate can be listed and the confusion that this can cause banks and other institutions must by law display the APR or Annual Percentage Rate. This allows any consumer to be able to compare what is being offered to them like for like across the different products. Image credit: profitf.com

This is very important when you consider how interest rates do work. For instance, a credit card that charges you 2% interest each month may sound like a good deal if you compare it to another that has a rate of 18% annually. But when you compound that interest you are looking at around 27% APR; so not such a great deal after all. The Effective APR has to provide you with the actual rate that you will pay annually as well as taking into account any additional charges that may be made on the loan.

## Effective Interest Method Formula and Calculations

Calculating the effective interest rate is not as hard as it may appear as long as you use the calculation correctly. The following is the calculation that you need to use:

r = (1 + (i / n))n – 1

r = The effective rate

i = The nominal interest rate

n = The number of terms

Effective interest rate example; if a loan states that it has a nominal rate of 6% and that interest is compounded monthly then the calculation will be:

r = (1 + (6% / 12))12 – 1

r = (1 + 0.005)12 – 1

r = 0.0617 0r 6.17%

So although the nominal rate may be 6% you will actually pay an effective interest rate of 6.17%.

The following table gives you a few more examples of effective interest rates depending on the nominal rates used and the rate at which the interest is compounded:

 Nominal Rate Quarterly Monthly Daily 5% 5.095% 5.116\$ 5.127% 10% 10.381% 10.471% 10.516% 15% 15.865% 16.075% 16.180% 20% 21.551% 21.939% 22.134%

This covers the basic calculations for your effective interest rate. Things can however become more complicated when calculating effective interest rate method deferred financing costs and other issues that you may be asked for as you advance through your studies.

## Issues with Doing Your Effective Interest Rate Assignments

Your assignment grades are often going to impact on your final grades so if you want to pass your course with the right grades and learn what you need for your future then you have to put in the work to get your assignments completed perfectly. Getting those great grades however is not always easy and there are many issues that students face when trying to do their homework on interest rates. The following are some of these issues:

• Not fully understanding what calculation that you need to use; always ensure that you fully understand precisely which type of interest rate calculation you are being asked for. If it is not clear whether you are being asked for effective or nominal then clarify with your tutor.
• Using the wrong formula; there is a huge amount of confusion between many websites online in areas such as finance and some sites do label formula incorrectly or state them wrongly. Where you can use what you have been shown in class or within your text book to ensure that you get the right one.
• Making calculations incorrectly; with lengthy formula it is easy to conduct the calculations in the wrong order and thus come up with an incorrect answer. You should always double check your answer. The easiest way to do this is to use one of the many online calculators that offer services to work out your effective and other interest rates.
• Submitting work that contains errors; not only should you always double check calculations you must always ensure that your writing is error free. Always proofread your work so that you avoid submitting assignments containing writing issues.

## Online Tools to Calculate Effective Interest Rates

The best way to check your own answers is to use an online calculator. There are many online and each will be able to calculate your effective rate quickly and accurately allowing you to double check your own answers. The following are a selection of sites that you can use: Image credit: markelhomes.com

As with your formulas it is important that you select the right tool to make your calculation. Do not just simply throw your assignment into these tools, work out your answers the way that is expected of you and show your calculations so that you fully understand how to solve equation problems in this area. Then use the tool to confirm that you have the right answer.

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