When is it appropriate to use effective interest rates?

Effective interest rates can be a very good way to find out which lender is the cheapest to borrow from. But is it really the case that it is always appropriate to compare effective interest rates? Here I will say what I think about the subject.

Very briefly, you can say that effective interest is the interest rate you get if you take into account all the costs of a loan and then calculate an interest rate that is annual based. This means that everything such as a newspaper fee and a setup fee are counted. Of course, the ordinary interest rate is also included. This means that the effective interest rate is normally a little higher than the nominal interest rate.

When is effective interest rate good?

bank

If you take a look at the different loan types, you will find that the effective interest rate is not always as interesting. This is great because it is an interest rate that is calculated on an annual basis.

What they have in common with mortgages, private loans and car loans is that they are all loans with a maturity of at least one year. This gives you a very good figure when it comes to effective interest rates that are easy to compare between different lenders. The lender with the lowest effective interest rate is the cheapest.

Mortgages, private loans, car loans etc.

Mortgages, private loans, car loans etc.

Of course, there are factors other than price to consider when borrowing money. But if you are only interested in borrowing from the lender that is the cheapest, the effective interest rate you should look at.

microloans

It is only on micro loans that it becomes doubtful if the effective interest rate is a good measure or not. This is because the loan is usually 30 – 90 days, which is well over a year. Effective interest rates will then work to calculate what it would cost to borrow money for a full year to pay off the first loan plus interest. So for a loan that is 30 days you would borrow another 11 times.

Of course, this is not how it works when you take a micro loan, but the idea is that everything should be repaid immediately when the term expires. That is why the effective interest rate becomes very high for a micro loan. The figures can reach many thousands of percent in a year, which is obviously not reasonable.

Therefore, I also think that one should not look so much at the effective interest rate when considering micro loans. Instead, take a look at the total cost of the loan. It is much easier then to create a picture of what a loan costs. For example, a loan of USD 2,000 for 30 days that has an interest cost of USD 300 will have an effective interest rate of 447.63%. It’s not so easy to immediately realize how much it costs directly. Then it is definitely better to think that this loan of USD 2,000 will cost me USD 300, do I think it is worth it?

One point it may be interesting to use effective interest rates

bank

When it comes to micro loans. That is if you compare two loans that are the same. For example, a loan of USD 2,000 for 30 days. The lender then who has the lowest effective interest rate will also be the cheapest.

However, it should be borne in mind that on all interest costs, you must deduct 30% on the declaration. And since there can be a big difference in the distribution between interest and fees with the lenders, this can have a strong impact.

Thus, the short summary is that I think effective interest rates are a brilliant way to compare different lenders as long as the loan extends beyond one year.