Are you planning to borrow money, and want to compare different loans with each other? Then it is wise to look extra closely at the effective interest rate. But what does that actually mean?
What is the difference between interest and effective interest?
What we in everyday parlance only call interest is actually nominal interest. News24 explains how so-called nominal interest and effective interest differ.
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What is nominal interest rate?
Nominal interest rate is the cost that the lender or bank charges to lend money. However, it only shows the interest rate for the loan itself, without including other fees, and is thus in principle always lower than the effective interest rate.
What is effective interest?
The bank or lender also charges fees for setting up and handling the loan. If you add up both interest and fees, you get the total cost of your loan, and this is the effective interest rate. Effective interest is often shown as a percentage.
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What does nominal interest rate mean?
The word “nominal” roughly means “on paper”, and thus means that the real value can be something completely different. The nominal annual interest rate is the interest rate that is usually referred to when discussing various loans and that lenders often highlight in marketing.
The nominal interest rate can be a good way to get an overview, but can also be misleading as the entire cost of the loan is not included.
What does effective interest mean?
As all fees are included in the effective interest rate, it usually means that you get a better picture of what the cost of your loan will be over the course of a year. The difference between the nominal interest rate and the effective interest rate can be large, as the fees can be high.
Some of the most common fees that are included in the effective interest rate can be, for example, airmail fees or invoice fees and set-up fees.
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Calculate the effective interest rate
The effective interest rate is = interest + fees.
However, calculating the exact effective interest rate on your own can be tricky, as it is calculated using a complicated formula. This formula takes into account, among other things, the size of the loan, how often the installments take place and the size of these.
Lenders are required to disclose their effective interest rates under the Consumer Credit Act, but it tends not to be marketed quite as clearly as the nominal interest rate. It is therefore important to check it clearly when you compare loans.
Sources: European Parliament, The savings banks, Nordea, Collect