What is Effective Interest Rate?
There are multiple options in the financial market when it comes to investment products, loan opportunities. All the financial instruments that we explore to give us better returns or loans with minimum interest rates are eventually correlated with how much interest is implied on respective instruments which contribute to our final decision making.
The “Effective Interest Rate” is hence the subtle way of comparing these instruments where we can deduce and finally decide whether to go ahead with loan/investment or not. Most importantly, it clarifies and evaluates the outcome where compounded interests are levied differently. It should be noted that the nominal interest rate is the simplest interest rate which is also called as a stated interest rate. There are no fundamentals such as compounding for the stated interest rate and totally differs from what we call effective interest rate (EIR).
Compound interest is calculated based on the principal amount but also includes all the accrued interest of previous periods of a loan or investment. It can, therefore, be called as ‘interest on interest’ and can enormously grow the sum at a speedy rate than how it goes with a stated interest rate which is calculated by principal amount only. The rate of compounding interest being accrued depends upon the frequency of compounding so the more compounding periods, the higher the compounding interest.
Formula of Effective Interest Rate
To understand the concept of Effective Interest Rate, the calculation can be carried out with the below formula:
- i = Annual rate of interest
- n = number of the compounding period
Let’s take an example of a 1-year investment through Bank X and Bank Y for $10k with below-compounding interest periods:
- Bank X pays 10%, compounded monthly:
- In this case, we have i = 10%, n = 12 [as its compounded monthly]
- Bank Y pays 10.3%, compounded quarterly:
- In this case, we have i = 10%, n = 4 [as its compounded quarterly]
As we can see, for a different set of compounding periods, the effective interest rate is varying. The more compounding occurs in one year, the more effective the interest rate would accrue.
Below is the description for a 10% interest rate with increasing compounding frequency in one year:
Importance of Effective Interest Rate
Below is what we can trace down as per the above understand it better
- Help to secure a worthful investment – As we now understand the impact of interest rate followed by compounding, we can confidently decide where can we invest reliably without getting pulled into advertisings posted by social media and blindly trust their strategies and get dissolved with the uncertainty that may hamper your earning expectations.
- Help to opt for a loan with full visibility of risk and issues – We know what the actual interest would be levied upon us on an annual basis for whatever compounding factor that loan follows. This would cause no hiccups at any point in time within the whole life of the loan.
- Enhance the way we analyze/compare financial products – Wouldn’t it give us a sigh of relief if we can conclude which investment or which loan is most beneficial for us to go ahead with? Well, understanding the impact of an effective interest rate than a nominal interest rate takes you one step further ahead to healthy future planning.
- Improve the decision making for loan/investment – knowing what’s presented by media Vs what matters the most while taking any financial decision can significantly change your returns and relieve your expectations based on your understanding of effective interest rate but not the simple interest rate.
It’s important to note that when banks charge the interest, the stated rate of interest is considered rather than the annual interest rate. Banks follow this, so it would appear to consumers as if they are paying a lesser interest rate.
For instance, for a loan stated with an interest rate of 20%, compounded monthly, the effective annual rate of interest would be 21.93%. However, the bank will advertise the stated rate of interest being 20% despite the effective interest rate of 21.93%.
In the case of you being an investor, a bank might advertise an effective interest rate rather than a stated interest rate as it would look to the consumers that they are being offered a higher interest amount.
For instance, for a deposit with a stated rate of 10% compounded monthly, the effective annual interest rate would be 10.47% which the bank will portray as is so that investors can be attracted and decide eventually to fall in with the advertising strategy. All in all, it’s just to display what’s more favorable.
As we are more inclined towards compounding when we talk about the effective interest rate, we need to thoroughly study the criticality of its reflection over our investments or loan. The financial market place is a labyrinth of opportunities followed by fortunate and misfortunate events. However, a good outcome resides for those who swing the sword at the right place at the right time. If we aim to opt for investing some portion of personal savings, the effective interest rate can significantly contribute to compare each pillar of investment you have enlisted to opt for and then deduce which one would benefit more in less time period and give you a better profit margin basis market situation and their specific provisions.
The power of compounding and drilling down the core of investment/loan, followed by the effective interest rate gives a great insight into how your overall financial status of the portfolio. The beauty of compounding has also been described as “the eighth wonder of the world” by Albert Einstein. It shall suffice to know for investors what magic it can bring in existence if followed the path of effective interest rate backed by the compounding interest.
This was a guide to the Effective interest rate. Here we talk about its formula, how to calculate effective interest rate along with an example of an effective rate, and also its importance. You can also check our proposed articles:-