What is an effective interest rate?
Effective interest rate, also called the annual effective rate or AER, applies to the actual amount paid in performing the composition period. It often differs from the annual percentage rate, which is an interest rate that is usually stated in credit conditions, because APR generally does not take into account the composition period. The calculation of an effective interest rate can often provide a more accurate idea of the amount of interest that they pay for a loan or receive from an investment. Then the nominal interest rate must be determined by diving APR by the number of compound periods. For example, if the credit card charges 15% APR and the interest compound each month, the nominal interest rate would be 1.25% per month. The person can then calculate the effective interest rate using the formula: [(1+I)^C - 1] x 100, where I am an equal to the nominal interest rate expressed in decimal form and C is equal to the number of compound periods expressed in integers. For previously listed credit card conditions, this would be [(1 + 0.0125)^12 -1] x 100, or 16.07%.
As shown by the above example, the effective interest rate is often higher than APR due to the effects of the composition. In terms of lending money, this generally means that the person will pay more in the long run, as the frequency of merger increases. Conversely, when it comes to investing, it may mean that a person in the long run makes more than the composition increases.
The ability to calculate the effective interest rate can be useful in comparing similar credit offers. Offers may have the same APR, but drastically different composition rates that affect the overall return in the case of a loan or payment in the event of an investment. For example, take two short -term payday loans offering $ 1,000 in US dollars for 25% APR to return in one year.
The first loan is not a compound interest, which means that the effective interest rate is also 25% and the debtor would owe $ 1,250 at the end of the year. SecondFaith interest once a month, raising effective interest rates to approximately 28% and the total number owed $ 1,280. In this scenario, although both loans seem to have the same interest rate at the beginning, the calculation of an effective rate explains better loan conditions.