What Are Stated Interest Rates & Effective Interest Rates?
Stated interest rates, also called "nominal" rates, can differ widely from effective interest rates, depending on whether they apply to savings or loans. The stated interest rate is the one quoted in savings, credit card, personal, auto and real estate loan ads or marketing materials. The effective interest rate can be higher for some savings and loans because of "interest compounding."
Other People Are Reading
-
APR and APY
-
Don't confuse APR (annual percentage rate), which must be disclosed for all loans, with effective interest rate. While the APR is the "true" interest rate and can differ greatly from the stated interest rate, except for loans with only a one-year term, the APR is usually less than the effective rate. The APY (annual percentage yield), quoted for savings earnings, is more representative of the effective interest rate. Over time, however, as you earn "interest on interest," even the APY will be lower than the effective interest rate.
Loans
-
In most cases, you should disregard the stated interest rate quoted for loans. The one exception is a mortgage loan. Unless you are contemplating a very poor mortgage loan, with many useless fees, the stated rate will be close to the APR and effective interest rate. Other loans are a different matter. The only time a stated rate or APR equals the effective rate are loans requiring only one annual payment. Since most loans are spread out over regular monthly payments, the effective rate will often be at least one-quarter to one-half higher than the stated rate or APR.
-
Effective Interest Rate Formula
-
Computing the effective rate mathematically is fairly simple. The formula: (1 + R / P)P - 1 . R equals the stated, or nominal interest rate, and P is the number of compounding periods, or number of monthly payments. The resulting number inside the parenthesis is the "power." For example, a loan with a stated rate of 7 percent for 24 months equals an effective rate of 7.24 percent. The calculation: (1 plus .07/24) to the 24th power minus 1.
Deferred Payments
-
Some credit cards, store cards and other loans advertise, "No payments for 'X' months." You might assume that the stated rate will be the effective rate, particularly if the term is 12 months. However, most of these loans include interest calculated monthly. Therefore, the usual effective interest rate calculations apply. These apparently appealing offers actually often create even higher effective interest rate levels. Since no payments are made during the opening "free" period, the original balance doesn't reduce, generating higher interest charges.
-
References
Resources
- Photo Credit Success & Wealth image by wayne ruston from Fotolia.com
