The effective rate on a loan is the interest rate after adjustment for compounding effects during the year.
The number of times a loan facility compounds can have a great impact on effective interest rate (EIR).
The formula for effective rate is as below:
Where n is the number of compounding periods each year.
For example, a $1,000 loan at a nominal 5% that compounds quarterly (4 times a year) would have an EIR of 5.095%. Resulting in an accumulated interest of $50.95 instead of $50.
Should it be compounded monthly (12 times a year), the EIR would be 5.116%.
While these variances can appear small, the real dollars involved can be pretty significant when we are talking about the big loans associated with mortgages, and over 20 to 30 years.
This is something to look at when you’ve found a great mortgage to refinance to but suspect that everything just seems too easy.
Lenders sometimes don’t disclose the number of compounding periods of a loan unless asked about it specifically.
Why they cannot just charge a borrower 5% when that’s what they advertised in the first place, I don’t know.
And their justifications are weak at best.
When it comes to investment analysis, meticulous investors are known to take into account the effective rate of returns when comparing between investments.
This is because every cent counts. And a huge investment can mean a huge loss even though the numbers appear small when expressed in percentages.