How to figure out annual interest rate

By India Today Web Desk: Calculating interest rate is not at all a difficult method to understand. Knowing to calculate interest rate can solve a lot of wages problems and save money while taking investment decisions. There is an easy formula to calculate simple interest rates. If you are aware of your loan and interest amount you can pay, you can do the largest interest rate calculation for yourself.

Using the simple interest calculation formula, you can also see your interest payments in a year and calculate your annual percentage rate.

Here is the step by step guide to calculate the interest rate.

How to calculate interest rate

Know the formula which can help you to calculate your interest rate.

Step 1: To calculate your interest rate, you need to know the interest formula I/Pt = r to get your rate. Here,

I = Interest amount paid in a specific time period (month, year etc.)

P = Principle amount (the money before interest)

t = Time period involved

r = Interest rate in decimal

You should remember this equation to calculate your basic interest rate.

Step 2: Once you put all the values required to calculate your interest rate, you will get your interest rate in decimal. Now, you need to convert the interest rate you got by multiplying it by 100. For example, a decimal like .11 will not help much while figuring out your interest rate. So, if you want to find your interest rate for .11, you have to multiply .11 with 100 (.11 x 100).

For this case, your interest rate will be (.11 x 100 = 11) 11%.

Step 3: Apart from this, you can also calculate your time period involved, principal amount and interest amount paid in a specific time period if you have other inputs available with you.

Calculate interest amount paid in a specific time period, I = Prt.

Calculate the principal amount, P = I/rt.

Calculate time period involved t = I/Pr.

Step 4: Most importantly, you have to make sure that your time period and interest rate are following the same parameter.

For example, on a loan, you want to find your monthly interest rate after one year. In this case, if you put t = 1, you will get the final interest rate as the interest rate per year. Whereas, if you want the monthly interest rate, you have to put the correct amount of time elapsed. Here, you can consider the time period like 12 months.

Please remember, your time period should be the same time amount as the interest paid. For example, if you’re calculating a year’s monthly interest payments then, it can be considered you’ve made 12 payments.

Also, you have to make sure that you check the time period (weekly, monthly, yearly etc) when your interest is calculated with your bank.

Step 5: You can rely on online calculators to get interest rates for complex loans, such as mortgages. You should also know the interest rate of your loan when you sign up for it.

For fluctuating rates, sometimes it becomes difficult to determine what a certain rate means. So, it is better to use free online calculators by searching "variable APR interest calculator", "mortgage interest calculator" etc.

To calculate interest rate, start by multiplying your principal, which is the amount of money before interest, by the time period involved (weeks, months, years, etc.). Write that number down, then divide the amount of paid interest from that month or year by that number. The answer is your interest rate, but it will be in decimal format. Multiply the decimal by 100 to convert the interest rate to a percentage. If you want to learn more, like how to talk to your banker about getting a lower interest rate, keep reading the article!

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Table of contents

1. What is an effective annual interest rate? 
2. An example of an effective annual interest rate
3. We can help

Matters of interest may not be interesting to many. Many people panic when it comes to complex financial jargon and acronyms. Nonetheless, if you’re the kind of business that extends credit, an understanding of how interest rates are calculated is essential. Indeed, if you run the kind of business that

What is an effective annual interest rate? 

In order to better understand the real-terms effects of interest on our businesses, we need to take compounding into account. Whenever interest rates are advertised (nominal rates), compounding is not taken into account. But unless we do this ourselves, we can be left with inaccurate

Simply put, the EAR is the interest that is paid back in real terms on any loan, credit card or other debt that you extend or use. It’s what you use to calculate your earnings on the credit you extend to your customers or your real-terms liability to your creditors. 

Understanding the EAR formula

Although there is a useful Effective Annual Interest Calculator that can automate the process for you, it’s important to get to know the formula for yourself. It requires you to understand two variables. The nominal annual interest rate that’s advertised (which we’ll refer to as r) and the number of periods within which interest (i) is compounded. Since this is usually measures in months, we’ll refer to this as m. 

Thus, the formula to calculate EAR (which we’ll refer to as i) looks like this:

i = (1+r / m) x m −1

The more compounding periods you have, the more you can expect your EAR to increase. So quarterly compounding produces higher returns than compounding every six months, while monthly compounding makes more than quarterly. Some creditors even compound daily.

Of course, if you’re not that mathematically inclined, this formula may be tricky to contextualise. So let’s look at an illustrative example.

An example of an effective annual interest rate

Let’s say you need a new piece of equipment for your company. You know that this piece of equipment will cost you £5,000 but you don’t have enough liquidity to cover that cost without disrupting your cash flow. So, you start shopping around for loans. 

Bank A offers a nominal interest rate of 10% compounded monthly. Bank B offers a nominal interest rate of 10.1% compounded every 6 months. That 0.1% may seem negligible. But which is really the better offer?  

Now that we know the formula, we can work it out. 

• EAR = (1 + (nominal rate / number of compounding periods)) ^ (number of compounding periods) − 1

• For Bank A, this would be: 10.47% = (1 + (10% / 12)) x 12 − 1

• For Bank B, this would be: 10.36% = (1 + (10.1% / 2)) x 2 − 1

So, although Bank B may have a slightly higher nominal interest rate, it has a lower EAR than Bank A because it compounds fewer times over the course of the year. While this difference may only result in a saving of £5.80 per year for a £5,000 loan, if you needed to borrow substantially more, the difference can really add up!

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