How to Calculate Effective Interest

When you are presented with an annual interest rate for a loan that is going to be paid off in multiple years, that rate is not the true interest rate you will pay on the loan. It is only the annual rate. To find out how much interest you will pay during the life of the loan, you need to multiply your loan by the effective interest rate.

Instructions

1

Write down the critical information for your loan on a sheet of paper so you have them to refer to when doing the calculation. This includes the annual interest rate that you agreed to when signing for the loan and the number of years before the loan is paid off. For this example, assume the annual interest rate is 10 percent and you have 5 years to pay off the loan.

2

Divide the annual interest rate by the number of years you have to pay off the loan. In this example, that would be .10 (interest rate expressed in decimal form) divided by 5, resulting in an answer of .02. To convert your annual interest rate to a decimal in this step, divide the annual interest rate by 100.

3

Add 1 to the result that you received in Step 2. In this example, it would be 1 added to .02, with a result of 1.02.

4

Subtract 1 from the number of years you have to pay off the loan. In this example, the math required is subtracting 1 from 5, resulting in 4.

5

Raise your result from Step 3 to the power of the result in Step 4. In this example, you would multiple 3 by itself four times. Written out, the equation would be 1.02 x 1.02 x 1.02 x 1.02. The answer to this equation is 1.0824.

6

Subtract 1 from the answer you received in Step 5. In this example, your result would be 1.0824 minus 1, which equals .0824.

7

Convert your answer in Step 6, which is in decimal form, to percentage form by multiplying it by 100. In this example .0824 x 100 = 8.24. Your effective interest rate is 8.24 percent in this example.