Glossary
What is Effective interest rate?
Definition
The effective interest rate is the true annual cost of a loan once the timing of payments, and often fees, are taken into account. For a flat rate loan it is the reducing balance rate that would produce the same payments, and it is typically 1.7 to 1.8 times the quoted flat rate.
To find it, calculate the installment, then solve for the periodic rate at which the installments repay the principal over the same number of periods. A spreadsheet's RATE function does this; for 12% flat over 12 monthly installments it returns about 1.79% a month, or 21.5% a year on a nominal annualized basis.
Fees raise the effective rate. A fee deducted at disbursement lowers the cash received while repayments stay the same, so the rate must be solved against the smaller amount. Showing borrowers the total repayable in currency, alongside the rate, prevents most disputes about cost.
See LoanTabs handle this in a live loan book. Browse the full lending glossary.
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