What Is the Difference Between Effective and Nominal Interest Rates?

The effective interest rate is a compound interest rate under the condition of compound interest payment. When compound interest payments are made more than once a year, the effective interest rate is naturally higher than the general market interest rate. Due to the emergence and emergence of the concept of effective interest rate, we call the market interest rate a flat interest rate.

Effective interest rate

Difference from nominal interest rate

The nominal interest rate only reflects the surface return of the funds after a certain period of time, while the effective interest rate reflects the actual time value of the funds, that is, the rate of change in the actual purchasing power of the funds after a certain period of time.

Interest rate effective period

Effective interest rate of interest-bearing cycle --- i.e. interest rate of interest-bearing cycle

Effective interest rate cycle

Effective interest rate cycle-If the effective interest rate cycle is used to calculate the effective interest rate cycle and take into account the interest regeneration interest factor in the interest rate cycle, the interest rate cycle interest rate obtained at this time is called the effective interest rate cycle ieff (also known as Interest rate cycle real interest rate).

There are two methods of calculating the effective interest rate.

The effective interest rate differs from the surface interest rate in terms of consolidated interest, expenses, interest calculation methods, and other loan assistance financial expenses. The effective interest rate should also include the cost of compulsory savings into the borrower's group funding contribution, as these are also capital costs. We do not consider transaction costs (financial or non-financial costs when the borrower obtains the loan, such as opening a bank account, transportation, child care, or opportunity cost) when calculating the effective interest rate, because these indicators are greatly affected by market influence . However, it is important to minimize the transaction costs of small credit institutions and customers when designing the issuance of credit and savings businesses.

When interest is calculated using a depreciated balance method and there is no additional cost of loan funds, the effective interest rate is the same as the literal interest rate. However, many small credit institutions use the flat rate method to calculate interest rates. They also charge service fees when interest is collected, or require borrowers to have deposits or contribute to group funds (credit or insurance funds). In this way, the cost of the borrower is not just the literal interest, but also other costs. The opportunity cost of the borrower must also be considered. They cannot reinvest the money. They must repay the loan in installments (time value of the line).

Small loan variables that affect effective interest rates include:

Literal interest rate

Interest calculation method: Attenuated balance or flat method

Payment of the initial interest on the loan (as a deduction of the principal issued to the borrower or payment of interest over the term of the loan)

Commission charged during the initial stage or during the loan process

Amount of guarantee, insurance, or group funds paid

Mandatory savings or compensation balances and corresponding interest paid to borrowers by a small credit institution or another institution (bank, credit union)

Payment frequency

Loan term

Loan amount.

When all variables are expressed as a percentage of the loan amount, a change in the loan amount will not result in a change in the effective interest rate. A currency-based fee (such as an application fee of $ 25) will change the effective interest rate when the loan amount changes; that is, paying a smaller amount of the loan at the same fee results in a higher effective interest rate.

Note that the estimation method does not directly consider the time value of the money and the frequency of payment. The internal rate of return method should be considered. Although the difference is small, the longer the loan term and the lower the frequency of payments, the greater the difference. Because the longer the loan is not paid, and the lower the frequency of payment, the greater the impact on costs, and the greater the difference between the estimated effective interest rate and the effective interest rate calculated using the internal rate of return method.