In the article, we consider that this is an effective interest rate.
As part of the analysis of a loan (or investment), it is sometimes difficult to determine its true value or profitability. There are various terms that are used to describe rates or profitability. For example, we can talk about the annual interest rate of return, effective and nominal rate, etc. Among all this, the most useful are the effective interest rates, which give a relatively complete picture of the cost of loans. To calculate them, you need to carefully study all existing conditions and perform simple calculations. Let us first understand what this economic term means.
Definition - what does this concept mean?
The effective interest rate is the real cost of the loan, taking into account all planned expenses that the borrower will incur during the period of using the loan. This category is used in banks in order to ensure that financial institutions prepare reports in accordance with international standards. It provides the same level of profitability through an even distribution of expenses and profits for the entire period during the term of the financial instruments. The effective interest rate is a value that is used to accomplish the following goals:
- Recognition of yield on a financial instrument.
- Calculation of the present value of future cash flow in order to calculate the impairment of a cash asset.
- Valuation of financial instruments carried at amortized cost (loans, deposits, debt securities).
Features of calculating the effective rate
How is the effective interest rate calculated?
It is calculated as follows:
- Initial measures for cash flows are determined.
- Establish a net carrying amount at initial recognition of a financial instrument.
- Determine the expected future cash flow.
- Predict the timing of upcoming cash flows.
- Calculate the effective interest rate.
- They draw up a schedule for recognition of income, repayment of the principal debt (face value) and interest on a financial instrument.
- Verification of the correctness of the calculations.
In the calculation of the effective rate, the Bank includes all commissions with fees that they paid or received. The expense of the transaction is also taken into account, which is an integral part of the profitability of a financial instrument.
How to calculate the effective interest rate? There is a special formula for this.
Formula for calculating the rate
In the calculation of such an economic category, the following formula is used:
Now consider what each of these indicators stands for. The value of CF i is the cash flow for the period t i . As for the symbol R ef, in this case we are talking about the effective interest rate for the period, which corresponds to the unit of measurement of the time of occurrence of cash flows. t i reports the duration of the stage of occurrence of the i-th financial flow, expressed in units of measurement of the appearance of funds (day, month, year).
Depending on the periods of recognition of interest income by banks, the annual, monthly or daily effective interest rate is applied. The current value of the expected future flows of financial instruments by the bank is calculated based on the indicator determined in the framework of the initial recognition of this monetary category. The difference between the carrying amount (i.e., amortized) and the present value of the future expected cash flows of financial instruments is recognized as interest income or expense.
In the temporary order of cash flow, there must be a zero period in which the funds that are provided or received by the bank in accordance with the terms of the financial instrument CF 0 are recorded. The size of the cash flow for zero periods is equal to the carrying amount in the event a financial instrument is recognized. It at the time of initial recognition, as a rule, consists of its fair price at the time of recognition and expense on a cash transaction.
The cash flow that the bank will pay is included in the calculation with the value “-”, and those that the financial institution will receive are included in the calculation with the “+” sign. The procedure for calculating effective interest rates is determined independently, and the calculations are carried out using an individual software and technical complex for the automation of various banking operations.
What else is the effective interest rate formula?
Nominal rate formula
Now consider a formula designed to calculate effective rates based on a nominal criterion. They are calculated according to the following simple scheme: r = (1 + i / n) ^ n - 1. In the above example, the value of r acts as an effective interest rate, in turn, i is a nominal instrument, and n indicates the number of interest calculation periods in a year. Next, we give a clear example of an effective interest rate.
Calculation
Consider a loan with an effective compound interest rate of 5%, which are accrued monthly. According to the existing scheme, the following will turn out: r = (1 + 0.05 / 12) ^ 12 - 1 = 5.12%. In the event that a nominal interest rate of 5% is accrued daily, then r = (1 + 0.05 / 365) ^ 365 - 1 = 5.13%. In this regard, attention is drawn to the fact that effective interest rates will always be greater than nominal equivalents.
References - Special Online Calculators
If necessary, you can find special online calculators on the World Wide Web, with the help of which you can quickly calculate the effective interest rate. In addition, in such a well-known and popular program around the world as Microsoft Excel, there is a function called EFFECT, which can calculate the effective rate for a given nominal value. Also, thanks to this function, it will be possible to determine the number of periods of interest accrual.
Features of the loan rate
How is the annual effective interest rate calculated?
In the event that the client sees that the bank is offering him 20% per annum, does this mean that he will overpay for this service? But such assumptions are a mistake of many modern borrowers.
- First of all, we are talking about the rate that will accrue on residual debt in proportion to the number of months in a year.
- In addition, if a loan is issued, for example, for three years, then this 20% rate will be applied to each 12 months of debt repayment separately (provided that early repayment has not been applied).
- Among other things, it does not reflect the real essence of the overpayment, but acts only as a financial instrument designed to calculate debt.
The annual interest does not take into account the various commissions and payments that the bank also assigns to the loan. It is worth emphasizing that the effective interest rate acts as a financial instrument that is used to calculate real overpayment. Sometimes it is called CPM, that is, the full cost of the loan. If the annual rate does not reflect the real situation of overpayment, what should borrowers pay their attention to? What does the effective interest rate include? This rate takes into account absolutely all expenses of the borrower that are associated with the execution of any type of loan, for example:
- Write-off of commission for granting a loan.
- Withholding funds for transaction support.
- Taking a commission for opening accounts and maintaining them.
- Interest for cash services and more.
Other fees
In addition to standard commissions, bank organizations include other fees in the effective interest rate on loans, depending on the type of financial loan. For example, in the event that a loan is issued with the pledge being left in the form of real estate or transport, then in the CPM also include the costs of the financial institution for the assessment of collateral property.
Notary services, which are necessary as part of some credit transactions, can also be included here. In the event that borrowers are connected to various insurance programs (life, disability, in case of reduction, protection of collateral, etc.), then the cost of the corresponding services is also reflected in the CPM. True, these funds are sent to pay for services not of the banking organization itself, but of insurance companies.
What is not included in the full cost of loans?
This rate does not take into account various fines and penalties, which are sometimes applied to borrowers in case of violation of loan agreements. This does not include monthly fees. The size of these payments is simply impossible to predict or they may not exist at all. In the event that it turns out to be a cash loan with a credit of funds to a plastic card or credit card, then the commission for cashing out will not be included in the effective interest rate.
Why do borrowers need to determine an effective interest rate?
To begin with, according to the law, every financial institution, starting to draw up loans, is obliged to inform the client of CPM. True, as a rule, in reality everything turns out completely differently, borrowers mistakenly believe that the annual interest rate serves as a basic indicator of overpayment, and banking institutions are in no hurry to announce the effective amount.
In the event that the bank does not report the effective rate first, then the borrower needs to take an interest in its value. Knowing the effective interest rate on a loan enables the client to objectively evaluate the available offers. One bank may offer an annual rate of 15%, but the CPM value will be equal to 40%, while the other, for example, provides an annual rate of 25%, but at the same time its effective value will be 30%.
Before undertaking a loan, it is mandatory to ask the banking institution for the calculation of effective rates, this is the only real indicator of overpayment.
Conclusion
Thus, the effective interest rate is the value based on which the expected future cash flows or payments are discounted over the expected period of existence of the financial instrument with respect to the carrying amount of the corresponding cash equivalent.