The effective rate indicates the interest at which capital is actually placed.
The first thing we have to do to establish the meaning of effective rate is to determine the etymological origin of the words that make up the term. Thus, first of all, we can explain that the rate comes from the Latin verb taxare , which can be translated as "set a maximum price."
Secondly, effective also comes from Latin. Specifically, it emanates from the word effectivus , which means "that carries something out."
The concept of interest
The relationship between two magnitudes is known as rate and expresses the relationship that exists between a quantity and the frequency of a certain phenomenon. Interest , on the other hand, is the value, usefulness, benefit or profit of something.
These two concepts allow us to approach the notion of interest rate , which is the price of money that is paid or charged to request or transfer it for a specific period. The nominal interest rate is one that reflects the profitability or cost of a financial product on a periodic basis.
The effective rate , on the other hand, indicates the rate at which the capital is actually placed. As the capitalization of interest occurs a certain number of times a year, an effective rate higher than the nominal one is obtained. The effective rate, on the other hand, includes the payment of interest, taxes, commissions and other expenses linked to the financial operation.
To calculate the effective rate, several factors must be considered.
Calculation of the effective rate
When it comes to calculating the effective rate, a series of fundamental elements must be taken into account. Specifically, you must have data such as the number of disbursements, the time that has passed between the start date and the disbursement date, the number of payments, the nominal interest, charges, commissions, the amount of the disbursement and also the value of the fee. With this last term we refer to both interest and amortization , commissions and another series of charges that may exist.
If, on the other hand, what we want is to calculate the annualized effective rate, the process is much simpler. The formula to do so would be the following: ie = (1+ik) k – 1.
In said formula, the established elements correspond to the following concepts: ie is the annualized effective rate; ik is the effective interest rate that refers to the payment time of the installment in question, and finally k is the number of installments that exist per year.
An example
If we have an interest rate of 2% per month, it could be said that the nominal rate is 6% per quarter (2% per month for three months). This rate, therefore, does not take into account the time value of money. The effective rate, however, also considers the capitalization of money.
The nominal rate is usually referenced to a period of one year, although it implies several interest payments in said period. The effective rate, for its part, only measures the performance in the period in which the payment or collection is made.