## Effective Interest Rate on a one Year Loan

If you borrow $1000 from a bank for one year and have to pay $60 in interest for that year, your stated interest rate is 6%. Here is the calculation:

**Effective Rate on a Simple Interest Loan = Interest/Principal = $60/$1000 = 6%**

Your annual percentage rate or APR is the same as the stated rate in this example because there is no compound interest to consider. This is a simple interest loan.

## Effective Interest Rate on a Loan With a Term of Less Than one Year

If you borrow $1000 from a bank for 120 days and the interest rate is 6%, what is the effective interest rate?

Effective rate = Interest/Principal X Days in the Year (360)/Days Loan is Outstanding

**Effective rate on a Loan with a Term of Less Than one Year=$60/$1000 X 360/120 = 18%**

## Effective Interest Rate on a Discounted Loan

Some banks offer discounted loans. Discounted loans are loans that have the interest payment subtracted from the principal before the loan is disbursed.

Effective rate on a discounted loan = Interest/Principal - Interest X Days in the Year (360)/Days Loan is Outstanding

**Effective rate on a discounted loan=$60/$1,000 - $60 X 360/360 = 6.38%**

As you can see, the effective rate of interest is higher on a discounted loan than on a simple interest loan.

## Effective Interest Rate with Compensating Balances

Some banks require that the small business firm applying for a business bank loan hold a balance, called a compensating balance, with their bank before they will approve a loan. This requirement makes the effective rate of interest higher.

Effective rate with compensating balances (c) = Interest/(1-c)

**Effective rate compensating balance= 6%/(1 - 0.2) = 7.5% (if c is a 20% compensating balance)**

## Effective Interest Rate on Installment Loans

One of the most confusing interest rates that you will hear quoted on a bank loan is that on an installment loan. Installment loan interest rates are generally the highest interest rates you will encounter. Using the example from above:

Effective rate on installment loan = 2 X Annual # of payments X Interest/(Total no. of payments + 1) X Principal

**Effective rate/installment loan=2 X 12 X $60/13 X $1,000 = 11.08%**

The interest rate on this installment loan is 11.08% as compared to 7.5% on the loan with compensating balances.

Here's an example of a loan amortization schedule for a bank installment loan.