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Importance of Effective Interest Rate In A Business

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Effective Interest Rate

While analyzing the structure of a loan or an investment, it becomes difficult for marketers to predict its true yield. This creates a demand for an effective method like the effective interest rate to help them do so efficiently. There are various terms used to describe the effective interest rate like annual percentage yield or rate, nominal rate, etc. Thus, Effective Annual Interest Rate (EAIR), Annual Equivalent Rate (AER) or effective rate is the most suitable method for marketers. This subject elucidates you with the true interest rate earned from an investment benefitting you to stay ahead of others. Here, you will learn about the methods of effective interest rate, its calculation, and significance in an economy.

What is an Effective Interest Rate?

An Effective Interest Rate (EIR) is a rate revealing the real profit earned on an investment or a loan over a certain period. It contributes majorly to compare the annual interests compounded in different periods like a week, month, year, etc. Unlike the Annual Percentage Rate (APR), EIR does not convert the interest rate into an annual rate compounded annually. This method holds a strong significance to evaluate the profits earned by any business over a certain period.

In simple words, an effective interest rate is a rate levied on a loan or investment restated on the nominal interest rate. In general terms, the interest rate is compounded annually with a stretch of time to pay the interest. This interest rate helps you to get an accurate knowledge of the true interest rate earned over a particular time. It is prevalent among the financial institutions to follow ideas like a mortgage loan having an annual rate of 4.5%.

Importance of Effective Interest Rate

5 Key Roles of Effective Interest Rate

  • Effective interest rate (EIR) plays a significant role in calculating the present value (PV) or future value (FV) for a given period.
  • It highlights all the future values in the form of grids for a given cash flow against a mortgage or loan.
  • It allows you to compare interests on different products inclusive of all the loans, credits, investments, etc.
  • The method also educates you regarding the deposits made on investment to calculate the compound interest differently.
  • This method helps you to learn the role of negative amortization and educates you with future values of the investment.

What is Effective Interest Rate Method?

The effective interest rate method is a widely recognized accounting technique used for providing discounts to a bond or investment. This method plays a major role in amortizing the amount of discounted bond to its interest expense over the bond's life. It is used by a buyer to account for the increment of a bond monitoring the premium being converted into interest expense. This method works on the value given in the books determining the amount of the bond to calculate the income from interest. Also, this method helps to evaluate the difference between interest income and the payment interest of the bond every year.

How Do You Calculate the Effective Interest Rate?

In the thriving economy, it is imperative for marketers to be precise and accurate while calculating the effective interest rate. To help them do so accurately, the effective interest rate formula is given as follows:

r = [1 + i/n]^n -1

where,

i = nominal interest rate

n = number of periods

r = effective interest rate

How Do You Find the Effective Interest Rate on a Discounted Loan?

It is widely known in an economy that every bond has a restated face value, interest rate, and maturity date. The primary purpose of this face value is to determine the amount that bond issuer needs to pay back. Also, it determines the interest rate estimating the interest earned over a certain period.

3 Steps to Calculate an Effective Interest Rate on a Discounted Loan

  • Initially, you need to evaluate the discounted amount by removing the price of a bond from its face value.
  • After subtracting the bond's price you need to divide the result by the number of bond payments left before its maturity.
  • Finally, the interest received for individual bond payments is added to the result giving you an effective interest rate.

Another way to calculate the effective interest rate on a discounted loan is given as:

The effective interest rate on a discounted loan = Interest/Principal - Interest * Days in the year (360)/Days Loan is Outstanding

OR

The effective interest rate on a discounted loan = $60/$1,000 - $60 * 360/360 = 6.38%.

Thus, the effective interest rate is greater on a discounted loan as compared to a simple interest loan.

What is the Difference Between Nominal and Effective Interest Rate?

 

Nominal Interest Rate

Effective Interest Rate

Interest rates are stated as annual percentages.

Actual interest earned or paid in a year or some other period.

It does not include any consideration of compounding. Also known as the Annual percentage rate (APR).

It is calculated on annual basis as the effective annual interest. Also known as Annual percentage yield (APY).

Interest may be compounded semi-annually, quarterly, and monthly.

Interest rate is compounded annually.

For example, a nominal annual interest rate of 12% based on monthly compounding means a 1% interest rate per month.

For example, for a nominal interest rate of 10%, the effective annual interest rate is calculated by taking the nominal interest rate an adjusting it for the number of compounding periods.

 

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