Annual Interest Rate

The annual interest rate determines the rate of interest that is applicable on the principal amount of a loanon an annual basis. These rates are applied on loans, mortgages, credit cards and investments. They are also called annualpercentage rate or APR.

Annual interest rates can take into account the interest on the principal loan amount, apart from additional costs, in particular ‘points’ on mortgage. Points are additional costs, such as application fees, credit report costs, title fees, loanprocessing fees and underwriting fees, which lenders charge while lending money to borrowers. However, some lenders excludeadditional charges like these to project low interest rates.

Types of Annual Interest Rates

Annual interest rates are of three types:

Stated annual interest rate: This is also called nominal annual interest rate. It represents the periodic interest ratethat is multiplied by the number of payment periods in a year. In this type of annual interest rate, the impact of inflation on the purchasing power of the loan amount and the effect of compounding are ignored.

Real interest rate: This interest rate considers the impact of inflationary pressures on the nominal interest rate and then helps to determine the actual cost of borrowing funds. Real interest rate is calculated by subtracting the rate of inflationfrom the nominal interest rate.

Effective annual interest rate: This rate, also called as effective interest rate or annual equivalent rate (AER), reflects annual interest rate that considers interest that is compounded annually. The AER can be calculated by using the formula:

Where,

r = effective annual interest rate,

i = nominal annual interest rate,

n = number of compounding period per annum.

Here is an example to clarify the effect of compounding on annual interest rate. A person takes a loan of $1,000 from a bank at a nominal interest rate of 10%. So, after a year, the total loan amount will become $1,100. Now, if interest is compoundedevery month, the effective annual interest rate will be 10.47% based on the AER formula. By the end of the year, the total loanamount will be $1104.70.

Although the difference in the nominal and effective annual interest rate is at first negligible, investors need to considerthat the compounded amount grows exponentially over the long term, so on multi-year loans this can amount to a substantial difference.