What is the effective annual interest rate?

Effective annual interest rates are the actual rate charged as interest against your loan.

Unlike Annual Percentage Rates (APR), which are nominal numbers meant to represent the effective annual interest but not actually mirror it, the effective annual rate is the exact interest rate that is charged on your loan.

 

When taking out an especially large loan, knowing this actual rate can represent a difference of thousands of pounds over time.

Effective annual rates are highly sensitive to both the nominal rate (the APR) as well as the frequency with which the interest is compounded (or charged against your debt). Effective annual rates are the actual annual rates as well, unlike APR which has the word "annual" in its name but is, in fact, unrelated to any type of annual fee.

The effective annual rate has a relatively simple calculation, though a calculator is often necessary. The equation looks like this:

EAI = ((1+I/n)^n)-1

Where "EAI" stands for effective annual interest rate , "I" stands for the interest listed as the APR, and "n" stands for the number of times per year that this interest is charged against your account. A monthly compounding interest, for example, would be charged 12 times per year. A bimonthly would be charged 6 times per year and so on.

So on the 5% APR, charged monthly, you would expect the equation to look like this:

EAI = ((1+.05/12)^12)-1 = .0512

And you would expect to pay an effective annual interest rate of 5.12% on the amount you have borrowed, assuming you have paid none of it back or made any payment to lower your debt.

APR is a way of standardizing the expected interest rate, but it is not the actual interest rate itself, and thus it can be misleading. The "Annual Percentage Rate" is also not annual, so it is possible to expect a different amount of interest than one actually receives.

 

The effective annual rate, on the other hand, will calculate exactly the amount you will be charged against your loans not including any additional fees or repayment problems.

The equation for the effective annual rates is also useful, because it can be used to calculate interest in your savings account as well. The equation for the effective annual rates is also useful, because it can be used to calculate interest in your savings account as well.

 

Although the annual percentage rate is a helpful way of quickly understanding the amount you will have to pay against your loans, it is not nearly as useful as the effective annual rate in determining the exact amount you will pay once your debt has been completely paid off.

 

 




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