What is an effective interest rate?
Are you taking out a loan or acquiring a financial commodity? If you are taking out a loan or trying to invest your money into a financial institution, you may need to know the factors that will affect your money either upwards or downwards, this includes effective interest rates.
If a lender tells you that you will need to pay your obligation with a nominal interest rate of x% over a certain number of months, it may help to ask what the effective interest rate is going to be.
Of course if you are asking about interest rates on investment, you will surely feel good about knowing the difference, but if you are taking out a loan or amortizing a certain financial product, it may be somewhat unnerving to know what the difference between nominal interest rates and effective interest rates are.
Nominal interest rates are often the interest rates that the lending institution will publish or offer. However, if the loan or financial product you are acquiring will need to be amortized on a monthly basis the effective interest rate is usually higher.
The effective interest rate varies depending on the term of the loan. Here is a simple computation that will help you understand the difference:
Let us assume you are given a 6% nominal interest rate on your loan. If you are going to pay your loan on a monthly basis, the 6% nominal interest will be computed on a compounded basis. Thus, the 6% divided by 12 months will be .5%. The .5% will be added to the loan amount you will need to pay on a monthly basis. The balance of the interest compounds until you are able to pay the entire amount. Effective interest rate in a nominal 6% interest is actually 6.17%.
This is not abnormally high if the loan amount is actually small, but if you are require a larger loan value, the .17% interest may still be considered large.
Of course, if you are taking out a loan, the interest applied on your funds is actually higher in order to cover costs of the lending institution. Again, if you realize the nature of the charges that you may incur, including credit rating issues, taking out a loan may still seem to be a very good idea.
Effective interests and nominal interests are just a few of the types of interest that the financial industry is using. It is always necessary that if you are dealing with financial institutions, you will have to ask the representative to detail the effective interest rates, nominal interest rates and other interests and charges that may be added onto the financial product.
By understanding these factors, you are actually making sure that you are knowledgeable of the transaction to ensure that you will have the means is which to pay them.
Always take the shorter route in financial management, if you must ask for help, do what is suggested. Individuals who do not ask usually end up loosing money because they do not understand the concept of financial management and how effective interest rates impact funds.
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