An effective interest rate is simply the total cost you have for borrowing money. Then the fee is also calculated for setting up the loan, the installment fees, and other fees that may be added by the lender to lend money. It is the borrower who pays all interest that the lender demands. An effective interest rate is stated as a percentage of the entire loan amount.
The interest terms and the fees that will be included in a loan are determined before. The terms for the interest rate are based on the borrower’s credit rating, how many years the loan is on and how much the loan should be on.
What does effective interest rate mean?
An effective interest rate means for the borrower the cost of the entire amount of the loan, ie the price tag of the loan. Then the cost is what it costs for the borrower to get a loan granted included. The interest rate can be different and it depends on various factors such as:
- The maturity of the loan (how many months / years the loan will be repaid)
- How big the loan amount is
- What risks the loan entails for the lender
Once these factors have been compiled, the effective can then be calculated.
How to calculate effective interest rate?
In fact, it is not so easy to calculate what a loan has for an effective interest rate and can be tricky for a common man. Therefore, those who lend money such as banks and lending institutions must state the effective interest rate directly in a loan agreement. According to the Consumer Credit Act, they are obliged to do so. Although as a borrower, it can be difficult to find the effective interest rate, because it is usually in the fine print of the loan. For the lenders, the nominal interest rate is rather marketed. Because there can be large differences between the nominal and effective interest rates.
To better understand how an effective interest rate is calculated, here are a few examples:
Example 1 – If you borrow USD 2,000 at a nominal interest rate of 0% and have a 12-month repayment period, as well as a setup fee of USD 395 and a fee of USD 29, then the effective interest rate is a total of 111.20%.
Example 2 – If you borrow USD 5,000 at a nominal interest rate of 0% and have a 12 month repayment period, as well as a setup fee of USD 295 and a deposit fee of USD 29, then the effective interest rate is a total of 27.42%.
It is very easy to believe that the higher the effective interest rate is, the higher the cost. Therefore, you should try to calculate the effective interest rate before applying for a loan, so as not to get any unpleasant surprises.
The formula for calculating the effective interest rate
There is a formula for how you can calculate the effective interest rate. The formula looks like this:
- The effective interest rate is the sum of: The time between the current payments and payments expressed in parts of a year.
- To get the sum: Divide the days between the current payments and payments by the number of days it is under one year (365).
- The formula looks like this: Sum = Number of payments and payments / 365
Here’s an example of how it might look when using the formula:
In this example, the effective interest rate is calculated as follows and a loan of USD 6,000 which is to be repaid in 90 days and has three repayments.
- First Refund: The time between the current payments and payments expressed in parts of a year = 30/365
- Second refund: The time between the current payments and payments expressed in parts of a year = 60/365
- Third reimbursement: The time between the current payments and payments expressed in parts of a year = 90/365
In addition, the monthly cost is USD 2,600 and then this sum can be added to the equation and looks as follows:
6,000 = 2,600 / (30/365) – 2,600 / (60/365) – 2,600 / (90/365) = 0
The effective interest rate will then be: 411.66%
It can be difficult to calculate it on paper, but using a spreadsheet program makes it much easier.
Use our calculator below to calculate the effective interest rate.
How much do you want to borrow? (kr) Nominal interest rate (%) Number of days Number of years Effective interest rate: Total cost:
For sms loans and other fast loans, it becomes a bit trickier as the loans last for such a short period of time, so most borrowers usually tailor interest rates according to the borrower’s situation. Then it is always best to ask at the hearing only what the effective interest rate will land on.