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Effective Interest Rate

Effective Interest Rate

The effective interest rate is an 'interesting' as well as important way of calculating the actual interest that you would be paying on a loan. In this article, we will look at this concept which you should know as a consumer.
Arjun Kulkarni
When a credit card company told you that they intend to charge your outstanding debt at an interest rate of a measly 3% every month, did you fall for the trap? If you did, no doubt you're going to be pretty much under the water and don't know what an effective interest rate is. So, here's an article to help you understand how your debt has taken a turn for the worse with the superfluous interest payments, when it was supposed to be 'only' 3%.

Method

To start off with, there's one very important thing that you need to understand about compound interest. When we calculate compound interest, we take into consideration the starting amount of principal, the interest rate, and the number of periods for which the amount will be compounded. Most often, the number of periods will be the number of years, which means that the principal will be compounded every year.

But then, there are calculations that break up the number of periods. In some cases, the principal is not compounded annually but six-monthly, monthly, or even weekly. For example, if it is compounded monthly, the figure in the number of periods will not be the number of years, but the number of years multiplied by twelve months.

But then, if you knew that, you also probably know that if the periods are broken up, the rate of interest is also multiplied by the number of months. Because if you didn't, it is going to come as a pretty big shock to you that the 3% monthly compounding which is calculated on your credit card debt is actually equivalent to 3 x 12 (months) i.e. 36%. So basically, for the year, your debt is being compounded at a whopping 36%.

Also, 36% for the year and 3% for the month aren't exactly the same thing. The 3% monthly compounding means you will pay more interest on your debt than you would on the 36% annual compounding.

The mathematical procedure described below, helps you understand at what rate you pay the interest on your debt, in annual terms.

Calculation

Because the monthly and weekly compounding can be a little misleading, this method can help you ascertain how much interest you would effectively be paying for the year. The formula mentioned below calculates the effective rate:

Effective Interest Rate = (1 + i/n)n - 1

where i = nominal rate and n = number of compounding periods per year.

This can help you know exactly how much you are going to end up paying as interest to the lender, and help you make a wiser decision while choosing any loan or credit.