How to Calculate the Effective Interest Rate on Loans?.

To calculate the effective interest rate (EIR) on loans, follow these steps:

Step-by-step

1. Identify the nominal interest rate (APR).
2. Determine the number of compounding periods per year (e.g., monthly, quarterly).
3. Use the formula: EIR = (1 + (APR/n))^n - 1, where n is the number of compounding periods.
4. Convert the decimal to a percentage by multiplying by 100.

Key Facts

• EIR provides a more accurate cost of borrowing compared to nominal rates.
• It factors in compounding interest and additional fees.
• Commonly used in mortgages and credit cards.
• Understanding EIR can save borrowers money over the loan term.

Examples or Use Cases

• A loan with an APR of 5% compounded monthly results in an EIR of approximately 5.12%.
• Comparing EIRs from different lenders can help in choosing the best loan.

Common Mistakes / FAQs

• Mistake: Confusing nominal and effective rates.
• FAQ: How does compounding frequency affect EIR? Compounding more frequently increases the EIR.