What Is Effective Interest Rate
Car loan rates can vary based on several factors including the make and model of the car you own, the loan amount and length of the loan, and the interest rates that apply to it. Figuring these factors out can be quite confusing, but with a little knowhow, it can be done.
One of the most baffling aspects about car loans is the effective interest rate, which is defined as the true rate of interest earned. Other terms can be used in lieu of effective interest rate, such as the yield to maturity, market interest rate, discount rate, annual percentage rate (APR), the internal rate of return, required interest rate, or targeted interest rate.
If you want to learn more about this particular aspect of your car loan, then read on.
Effective interest rate vs. flat interest rate
Generally, the rate that appears on a personal or car loan quotation is the flat rate, and not the effective interest rate. A flat rate is rather easy to compute, as it simply represents the interest calculated on your full principal with respect to the number of years of your loan.
All you need to do to compute for flat interest rate is to multiply a given interest rate with the principal, then multiply it with the number of years, add the resulting amount to the loan principal, then divide it according to the number of months that you need to complete your loan payments.
For a more concrete example, say you’re given a loan amount of P1 million with a 4.0 percent flat interest rate:
- Interest payment equals P1 million x 5.0% = P50,000
- Total interest paid equals P50,000 x 5 years = P250,000
- Installment amount per month equals (P1 million + P250,000)/60 months = P20,833.33
A flat rate calculation assumes that the whole principle is borrowed for the entire length of the loan. An effective interest rate calculation on the other hand, takes into account that you are NOT borrowing the whole principal for the total length of the loan.
The effective interest rate can differ from that stated on a loan document, but ordinarily, a higher effective rate can make it difficult for a borrower to pay off his car loan. Thus, when looking for a lender to work with, it’s can be helpful to find one that offers the lowest effective interest rate.
Calculating the effective interest rate of your car loan
As a borrower, there are certain things that you need to know about the effective interest rate that’s bundled into your auto loan package. These are:
- The actual lent amount
- The actual amount of interest paid
- The number of times the debt is compounded in a year
If you want to know the impact of compounding on the interest rate, you can compute for the effective interest rate by following these steps:
- Identify the compounding period (whether monthly, quarterly, bi-annually, annually, etc.)
- Identify the flat interest rate stated in the car loan document
- Compute for the effective interest rate using this formula:
(1 + i / n)n – 1 = effective interest rate
In this formula, ‘i’ represents the effective period interest rate, which can be obtained by dividing the nominal annual interest rate by the number of periods per year (n). This would help us arrive at this computation:
Effective Period Rate = Nominal Annual Rate / n
So if the nominal interest rate is 5% and compounded monthly, we get:
0.05 / 12 = 0.4167%
The effective annual interest rate is equal to 1 plus the nominal interest rate percentage divided by the number compounding periods per year (n) to the power of (n) minus 1. Thus, we arrive at the formula given above.
To cite a solid example, let’s say that a loan document states that the flat interest rate is 5 percent and mandates monthly compounding. By inputting these details into the formula above, we arrive at the following effective interest rate:
(1 + 5% / 12)12 – 1 = 0.05116 or 5.116%
Additional factors that can affect effective interest rate
Other factors can alter the effective interest rate amount to an even greater extent, including (but not limited to):
- Interest-related fees – you may be required to pay additional fees for any added tasks that your loan may incur. You need to include these fees into your calculation as they can add up to a pretty hefty amount if you’re not careful.
- Altered amount lent – if the lender believes that the market interest rate doesn’t match the stated interest rate quoted to the borrower, the lender can bid lower or higher than the stated amount to acquire the debt. Thus, if the market rate is lower, the borrower will have to pay more for the loan. Conversely, if the market rate is higher, the borrower will have less debt to pay.
Why should you compute for the effective rate of interest?
Computing for the effective interest rate is the preferred manner of amortizing the premium or discount on bonds payable. The effective interest rate will be multiplied to the carrying value of the bonds to identify the bond interest expense. The dissimilarity between the bond interest expense and the cash interest payment is the amortized amount.
By performing a thorough analysis and computation of the effective interest rate of your car loan you may discover that a particular loan proposal may not be to your advantage. You may then decide if you should negotiate the terms of the loan or work with a different provider entirely. In both cases, you may end up saving a significant amount.
Should or shouldn’t you get that car loan?
Your financial situation is different from everyone else’s, so what may not work for you may work for somebody else. So should you take out a car loan on a rate of 5 percent for 5 years? It’s all up to your financial standing.
If you want to know the right answer to your specific situation, it can help to consult a financial advisor on the matter. With their help, you’ll be better equipped with the information you need to proceed.