The effective interest rate is Definition, calculation features, example and recommendations

2024 Author: Howard Calhoun | [email protected]. Last modified: 2024-01-02 13:48

In this article we will consider that this is the effective interest rate.

As part of the analysis of a loan (or investment), it is sometimes difficult to determine its true value or profitability. There are different terms that are used to describe rates or profitability. For example, we can talk about annual percentage yield, effective and nominal rate, and so on. Among these, the most useful are effective interest rates, which give a relatively complete picture of the cost of borrowing. To calculate them, you need to carefully study all the existing conditions and perform simple calculations. Let's first understand what this economic term means.

Definition - what does this concept mean?

The effective interest rate is the real cost of the loan, taking into account all the planned expenses that the borrower will incur during the period of using the loan. This category is used in banks for the purpose ofensuring that financial institutions prepare reports in accordance with international standards. It provides the same level of return by evenly distributing expenses and profits for the entire period during the life of financial instruments. The effective interest rate is the amount used for the following purposes:

• Recognition of yield on a financial instrument.
• Calculation of the present value of a future cash flow to calculate the impairment of a monetary asset.
• Valuation of financial instruments carried at amortized cost (loans, deposits, debt securities).

Features of calculating the effective rate

How is the effective interest rate calculated?

It is calculated as follows:

• Determine baselines for cash flows.
• Establish the net carrying amount on initial recognition of a monetary instrument.
• Determine the expected future cash flow.
• Predict the timing of upcoming cash flows.
• Calculate the effective interest rate.
• Create a schedule for the recognition of income, repayment of principal (nominal) and interest on a financial instrument.
• Checking the correctness of the calculations.

The bank's effective rate calculation includes all commissions with fees paid or received by it. taken into accountas well as the cost of the operation, which is an integral part of the profitability of the financial instrument.

How to calculate the effective interest rate? There is a special formula for this.

Formula for calculating the rate

As part of the calculation of this economic category, the following formula is used:

Now consider what each of these indicators means. The value CF_i is the cash flow for the period t_i. As for the symbol R_ef, , in this case we are talking about the effective interest rate for the period that corresponds to the unit of measurement of the time of occurrence of cash flows. t_{i reports the duration of the stage of the appearance of the i-th financial flow, expressed in units of the appearance of funds (day, month, year).}

Depending on the periods of recognition of interest yield by banks, annual, monthly or daily effective interest rates are applied. The present value of the expected future flows of financial instruments by the bank is calculated using the indicator determined as part of the initial recognition of this monetary category. The difference between the carrying amount (ie amortized price) and the present value of future expected cash flows of financial instruments is recognized as interest income or expense.

In the time order of the cash flow, there must be a zero period, in which the funds that are provided orreceived by the bank in accordance with the terms of the financial instrument CF_{0. The cash flow for zero periods is equal to the carrying amount if the financial instrument is recognised. It at the time of initial recognition generally consists of its fair value at the time of recognition and the cash transaction expense.}

The cash flow that the bank will pay is included in the calculation with the value "-", and those that the financial institution will receive are included in the calculation with the "+" sign. The procedure for calculating effective interest rates is determined independently, and the calculations are carried out using an individual software and hardware complex for automating various banking operations.

What other effective interest rate formula is there?

Formula for nominal rates

Now consider the formula for calculating effective rates based on nominal criteria. They are calculated according to the following simple scheme: r=(1 + i/n)^n - 1. In the above example, the value of r is the effective interest rate, in turn, i is the nominal instrument, and n indicates the number of interest periods per year. Below is a good example of the effective interest rate.

Calculation

Consider a loan that has an effective compound interest rate of 5% compounded monthly. According to the existing scheme, the following will turn out: r \u003d (1 + 0.05 / 12) ^ 12 - 1 \u003d 5.12%. In that case,if the nominal interest rate of 5% is charged daily, then r=(1 + 0.05 / 365) ^ 365 - 1=5.13%. In this regard, attention is drawn to the fact that effective interest rates will always be higher than nominal equivalents.

Recommendations - special online calculators

On the World Wide Web, if necessary, you can find special online calculators with which you can quickly calculate the effective interest rate. In addition, in such a well-known and popular program around the world as Microsoft Excel, there is a function called EFFECT, which can calculate the effective rate for given nominal values. Also, thanks to this function, it will be possible to determine the number of periods of interest accrual.

Features of the loan rate

How is the annual effective interest rate calculated?

In the event that a client sees that the bank offers him 20% per annum, does this mean that he will overpay this amount for the service rendered? But such assumptions are the mistake of many modern borrowers.

• First of all, we are talking about the rate that will be charged on the residual debt in proportion to the number of months in a year.
• In addition, if the loan is issued, for example, for three years, then this rate of 20% will be applied to each 12 months of repayment of the debt separately (provided that early repayment was not applied).
• Among other things, it does not reflect the real essence of the overpayment, but actsonly a financial instrument designed to calculate debt.

Annual interest does not take into account various commissions and payments, which are also attributed to the loan by the bank. It is worth emphasizing that the effective interest rate is a financial instrument used to calculate the real overpayment. Sometimes it is called TFR, that is, the full cost of the loan. In the event that the annual rate does not reflect the real situation of overpayment, then what should borrowers pay attention to? What does the effective interest rate include? This rate takes into account absolutely all the expenses of the borrower that are associated with obtaining any type of loan, for example:

• Write off the commission for issuing a loan.
• Withholding funds for transaction support.
• Charging fees for opening and maintaining accounts.
• Percentage for cash service, etc.

Other fees

In addition to the standard commission, banking organizations also include other fees in the effective interest rate on loans, depending on the type of financial loan. For example, in the event that a loan is issued with a collateral in the form of real estate or transport, then the CPS also includes the costs of a financial organization for assessing collateral.

Here you can also include the services of a notary, which are necessary as part of some credit transactions. In the event that borrowers connect to different insurance programs(life, disability, in case of reduction, protection of collateral, etc.), then the cost of the corresponding services is also reflected in the CPS. True, these funds are sent to pay for the services not of the banking organization itself, but of insurance companies.

What is not included in the full cost of loans?

This rate does not take into account various fines and pen alties that are sometimes applied to borrowers in case of violation of loan agreements. This does not include fees for making a monthly payment. The size of these payments is simply impossible to predict, or they may not exist at all. In the event that it turns out to be a cash loan with funds credited to a plastic card or credit card, then the commission for cashing out will not be included in the effective interest rate.

Why do borrowers need to determine the effective interest rate?

Let's start with the fact that, according to the law, each financial institution, starting to issue loans, is obliged to inform the client of the PSK. True, as a rule, everything turns out quite differently in reality, borrowers mistakenly believe that the annual interest rate serves as a base indicator of overpayment, and banking institutions are in no hurry to disclose the effective amount.

In the event that the bank does not report the effective rate first, then the borrower should inquire about its value himself. Knowing the effective interest rate on the loan allows the client to objectively evaluate the available offers. One bank may offer an annual rate of 15%, but at the same time the value of the TIC will be equal to 40%, and the other, for example,provides an annual interest rate of 25%, but at the same time its effective will be 30%.

Before taking on a loan, it is imperative to ask a banking institution for the calculation of effective rates, this is the only real indicator of overpayment.

Conclusion

Thus, the effective interest rate is the amount by which expected flows of future receipts or payments over the expected life of a financial instrument are discounted to the carrying amount of the corresponding cash equivalent.