Effective Interest Rate

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An effective interest rate is a type of interest rate applied to a loan or other financial product that is restated from the nominal interest rate. In addition, effective interest rates acquire compound interest that can be paid in arrears.

Generally this type of interest is used in the comparison of annual rates with different compounding terms. For example, some loans collect interest on daily, weekly, monthly, or yearly terms. Unlikely other types of interest, effective interest can be applied to terms of a loan based on a variety of circumstances. Therefore, a bank can calculate the effective interest fees differently based on income gained from other fees, monetary profits gained from loan portfolios, or other circumstances that would require different borrowers to repay different interest rates.

Furthermore, an effective interest rate also has two main differences from the typical annual percentage rate, or APR. For one, unlike many annual percentage rates, an effective interest rate does not usually include one-time charges when the loan is processed. Secondly, effective interest rates do not have to abide by the same federal regulations as annual interest rates. For example, many times APRs have certain caps on the amount of interest that can be charged on a loan.

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