How to Calcuate Effective Interest Rate

If you are thinking about taking out a loan you can use the effective interest rate to compare the loans. The item you want to compare is the number of compounding periods, during the year or term of the loan that each loan has. The more compounding periods a loan has the higher the effective interest rate will be. So if a loan is compounded daily, as opposed to semi-annually, the effective interest rate will be higher. Compounding is the process of adding any accumulated interest to the loan balance at that point.

Instructions

1

Find out all of the terms of your loan. When you are ready to calculate the effective rate of interest you will need all of the facts and figures of a loan including the amount, interest rate and the number of compounding periods. If you have a loan for $15,000 with an interest rate of 7 percent, which is compounded semi-annually, you can compute the effective interest rate. The new rate or the effective interest rate will be higher than the interest rate of 7 percent.

2

Calculate the interest charge without compounding. You can find out how much interest is charged at the end of the year without compounding for the sake of comparison. To calculate the interest charged or earned you will first need to know the interest rate and the amount of the loan. Take $15,000 and multiply it times the interest rate of 7 percent and you get $1,050. This represents the amount of interest you will be charged at the end of the year.

3

Calculate the interest during the first compound period. Now you need to find out how much interest has accrued during the first compound period which is the six-month mark. That would be $525. Add this figure to the loan amount of $15,000 which brings the total to $15,525. For the remaining six months the interest will accrue based on the new balance because it was compounded. Take 0.035 percent and multiply it by $15,525 and you get $543.37.

4

Add the two interest figures together. When you add $525, which is the amount of interest earned during the first six months or the first compound period, to $543.37, you get $1,068.37. Compare this figure to the interest earned when there was no compounding ($1,050). Now to get the effective interest rate take $1,068.37 and divide by the loan amount of $15,000 and you get an effective interest rate of 7.12 percent.

5

Use an effective interest rate calculator (available free in the Resources section). If you have an effective interest calculator you can calculate the effective interest rate by using the interest rate and the number of compound periods. No other information is needed. If you have an interest rate of 12 percent which compounds 365 times, the effective rate of interest will be 12.7 percent.