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What Is the Effective Interest Rate in a Loan?

The effective interest rate isn’t just another number in the sea of numerals when getting a loan. It shows just how much compound interest will cost you.

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effective interest rate When you take out a loan, there are so many numbers and terms to keep track of. So, do you really need to understand yet another term, effective interest rate? Unfortunately, yes, because this shows you how much in interest this loan will really cost you.

When you get a loan, whether it’s a personal loan, payday loan, mortgage or an auto loan, you will see various interest rates along the way, including stated interest rate and annual percentage rate. But you will almost never see the effective interest rate, despite its importance in financing.

What is this important interest rate and how do we find it? Keep reading to find out.

What types of interest rates are there?

There are plenty of types of interest rates out there in the financial world, but there are only three that matter to most borrowers. These are stated interest rate, annual percentage rate and effective interest.

Stated Interest Rate

This is that super-low rate that the lender initially flashes in your face. It looks extremely low, so it sucks you into the bank, leading you to believe you’re about to get an amazing deal. Sadly, this is only the straight interest the bank charges to lend you money. It does not account for additional fees associated with borrowing, like origination fees, nor does it account for compounding interest,

Annual Percentage Rate

APR is the rate you see when you are finalizing your paperwork. This is almost always higher than the shown interest rate because it rolls all the fees associated with borrowing into the rate. So, if the bank charges you a $5,000 origination fee, this is rolled into the payments and increases the APR.

Effective Interest Rate

The effective interest rate is the total interest cost associated with the loan. All loans have compound interest, meaning the bank includes the previous month’s accrued interest when calculating your next month’s interest. The effective rate takes this into consideration and expresses it as a rate that is generally slightly higher than the stated interest rate but lower than the APR.

Calculating the Effective Interest Rateeffective interest rate

The effective interest rate is one of the easier financial calculations to make, but you still need an in-depth equation to figure it out. This equation is r = (1 + i/n)^n – 1. The “r” is your effective interest rate, “i” is the stated interest rate in its decimal format (3% is 0.03) and “n” is the number of times the interest compounds in a year. Generally, the “n” will be a 12 because most loans compound monthly, but, in some rare case, it can also be daily, weekly or continuously.

Let’s say you have a $100,000 loan with a 3% stated interest rate that compounds monthly, here is how to calculate the effective interest rate:

r = (1 + 0.03/12)^12 – 1

That would equal a 3.04% effective interest rate.

While that may seem insignificant and trivial, this can be a helpful tool when comparing loan offers that are virtually identical terms.

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