In credit card advertisements and loan quotes, the lender will typically show a nominal interest rate. This is known as the stated interest rate and, depending on several factors, can be significantly different than the effective interest rate. To understand the true cost of a loan, it is important to know the effective interest rate.
According to the Truth in Lending Act, lenders are required to disclose the APR or annual percentage rate. This figure comprises the overall yearly cost of a loan including noninterest fees (such as origination fees, membership fees and application fees). This is called the nominal APR or the stated APR.
What the nominal APR does not factor in is the compound interest. Compound interest refers to the amount of interest that is added back onto the principle during each payment period. You are then charged interest on the new principle amount.
The compounding period is the amount of times during the year when you are charged a finance fee. For most credit cards and loans, this is monthly. So, for one year, you would have 12 compounding periods.
Calculating Effective Interest Rate
To calculate the effective interest rate, use the following formula: (1 plus i/n) to the nth power minus 1 where n is the compounding periods. So, for a 25 percent interest rate, you would calculate (1 plus .25/12) to the 12th power minus 1, which equals 28.073 percent.
The difference between the interest calculated from the stated interest and the effective interest can be quite significant. Using the above example, you would pay $2,500 in interest for a $10,000 one-year loan, if you were only charged interest for one year (thus, the effective interest rate would remain 25 percent). However, for a monthly compounding period, you would pay $2,807.03 in interest, because the effective interest rate would be 28.073 percent.