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Effective Interest Rate Explained
Financial - Examples for the financial calculators
Friday, 03 April 2009 08:17

The effective interest rate can be seen as a fixed imaginary interest rate. This interest rate is equivalent to the interest rate you get or pay combined with any conditions applying to your loan or bank account. Such conditions can be extra costs, or extra benefits, or variations in the interest rate.

Suppose you save $ 100 in a savings account. One year later the banks pays you 10% interest. Once you have received the interest you withdraw your money and the bank charges you a fee of 1%. So if you withdraw your money after a year you receive (100*(1+10%))*(1-1%) = 110*0.99 = $ 108.9. So after one year the 10% combined with 1% withdrawal fee is equivalent to 8.9%. So in this case the effective interest rate is 8.9%.

Suppose you have a savings account paying 10% interest per year. Usually banks pay the interest afterwards, at the end of the year. But this bank account is different because it pays interest upfront. Because you have the ability to reinvest the 10% interest paid upfront into a second savings account the interest rate is effectively a bit higher than 10%.

For a variable interest mortgage the concept can be explained as follows. Suppose you have a mortgage with a variable interest rate. So you end up paying a different amount each month. You want to find a mortgage with a constant interest rate where you basically pay the same interest. Of course then you pay the same amount every month. Via a mathematical formula this constant monthly amount is equivalent to the varying amounts of your variable interest mortgage.

As in the previous example this formula takes into account when you pay what. If you pay the largest sums during the first terms of the loan this will translate into a higher effective interest rate.

At this website you will find calculators and examples computing this equivalent annual rate for many situations.