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%The effective rate of interest is 18% since you only have use of the funds for 120 days instead of 360 days.
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.