Effective Interest Rate

When a credit card company tells you that they intend to charge your credit card debt at an interest rate of a measly 3% every month, did you fall for the trap? Thinking that the interest rate for the year on the debt is only 3%, making it one of the cheapest forms of debt available around? If you did, no doubt you're going to be pretty much under the water and don't know what an effective interest rate is. So, here's an article to help you understand how your debt has taken a turn for the worse with the superfluous interest payments, when it was supposed to be 'only' 3%.

Effective Interest Rate Method

So, before we go ahead with the effective interest rate definition, there's one very important thing that you need to understand about compound interest. If you know how to calculate compound interest, you will know that, we take into consideration the starting amount of principal, the interest rate and the number of periods for which the amount will be compounded. Most often, the number of periods will be the number of years, which means that the amount of principal will be compounded every year.

But then there are some principals, some calculations that break up the number of periods. In some cases, the principal is not compounded annually, but six-monthly, monthly or even weekly. When it is compounded thus, say for example, it is compounded monthly, the figure in the number of periods will not be the number of years, but the number of years multiplied by 12, due to the monthly compounding.

But then, if you knew that, you also probably know that if the periods are broken up, the rate of interest is also divided by the number of months. Because if you didn't, it is going to come as a pretty big shock to you that the 3% monthly compounding which is calculated on your credit card debt is actually equivalent to 3 X 12 (months) = 36%. So basically, for the year, you're debt is being compounded at a whopping 36%.

In case you did know about the interest rate being divided and broken up into the number of periods, you probably did not know that 36% for the year and 3% for the month aren't exactly the same thing. The 3% monthly compounding means you will pay more interest on your debt than you would on the 36% annual compounding.

The definition will tell you that this little mathematical procedure helps you understand at what rate you pay the interest on your debt, in annual terms. At the end of this little calculation you will be all the wiser regarding your debt.

Effective Interest Rate Calculation

Putting it simply, the effective interest rate gives the amount of interest which you effectively pay for the year. Because the monthly and weekly compounding can be a little misleading, the method can help you ascertain how much interest you would effectively be paying for the year. The effective interest can be calculated by the simple mathematics formula:

Effective Interest Rate = (1 + ⁱ/_n)ⁿ - 1

where i = nominal rate and n = number of compounding periods per year.

So, this was how to calculate the effective interest or the effective annual interest rate. By calculating the effective mortgage interest rate one can know exactly how much one is going to end up paying as interest to the creditors and be able to make a wiser choice while choosing a form of debt.