How to Calculate the Effective Interest Rate on a Line of Credit

The effective interest rate of a loan, also known as the effective annual interest rate, is different from, and often higher than the annual percentage rate (APR) because it reflects the effects of compounding interest. Calculating the effective interest rate on a line of credit will provide a more accurate picture of the loan's actual interest versus its APR.

Instructions

1

Move the decimal point in the stated interest rate to the left two places to convert from a percentage to a decimal number. Divide this figure by the number of periods that the loan compounds interest. For example, with an interest rate of 5.25 percent, move the decimal point to convert it to a decimal fraction of 0.0525. This is the periodic rate. Divide by 12 months in a year if it's compounded annually: 0.0525/12 = 0.0438.

2

Add one to the periodic rate. In the example, 1 + 0.0438 = 1.0438.

3

Raise this figure to the power of the number of compounding periods. In the example there are 12 compounding periods. Therefore, raise 1.0438 to the 12th power, which is 1.673.

4

Subtract one from this figure. In the example, 1.673 - 1 = 0.673. This is the effective annual interest rate in decimal form.

5

Multiply the effective interest rate expressed as a decimal times 100. This is the effective annual interest percentage rate. In the example, the effective annual interest rate on a line of credit with a stated rate of 5.25 percent is 6.73 percent.