Effective interest

Effective interest CRE

Effective interest is perhaps the truest description of interest payable by a borrower.

It refers to the total annual (or monthly) cost of interest, taking into account the monthly, weekly or daily compounding of interest.

In this way it differs to nominal interest – which can understate interest payable.

Example

A lender lends money at 15% p.a. effective.

The monthly interest calculation is therefore ((100% + 15%) to the exponent of (1 / 12 months)) – 1 = 1.171%.

The calculation is not 15% divided by 12 months.

That is because the interest compounding monthly at 15% / 12 results in “interest on interest”.

Compounding the answer by 12 months will result in an annual interest rate of 16.075%.

The calculation for this is [ (100% + 1%) ^ 12 ] – 100%

Quick sums using Excel

To convert:

  • Nominal interest to effective interest, where nominal interest is expressed as an annual value: = (1 + (annual interest rate / 12 months) ^ 12) – 1
  • Nominal interest to effective interest, where nominal interest is expressed as a quarterly value: = (1 + (quarterly interest rate / 3 months) ^12) – 1
  • Effective annual interest to nominal: = (1 + effective annual interest rate) ^ (1 / 12) x 12 months. The first part gives you the monthly rate. The second part transforms it into nominal

Related terms

Content categories

Subscribe to the Mavenway

Want this content in your inbox monthly?

Menu