Nominell Og Effektiv Rente – Effective vs. nominal interest rate

Financial experts are in the best position to understand economic terms. However, even laymen ought to be aware of a few important economic terms. These are the kinds of economic terms that can impact their financial decisions.

Effective vs. nominal interest rate

Some of these include inflation, deflation, asset, liability, income, market monopoly, and interest rates. For instance, a good knowledge of what interest rate implies can help people make better decisions when taking loans. This knowledge will also ensure that people invest in profitable ventures.

Considering how important the knowledge of this economic term is, this article will shed light on two of the major types of interest rates – nominell og effektiv rente (nominal and effective interest rates). Our focus will be more on this economic term as it applies to loans. By the way, there are other types, and they include – variable, real, accrued, fixed, and simple interest rates.

The difference between nominal and effective interest rates.

The inability to tell the difference between these two types can be very costly for borrowers and investors. For instance, it could mean that borrowers end up paying more money than they thought they would to obtain a loan.

Interest rates

All this goes to prove the importance of having a good understanding of what both types of interest rates are. There is perhaps no better way to do this than to tell their differences. In light of this, some of the ways they differ from each other include the following:

Their definitions.

The nominal interest rate (NIR) is restricted in its cost assessment. It only factors in the base rate of the loan. It does not consider the other rates associated with the loan. This type is what is often advertised by lenders and is why borrowers need to be incredibly careful.

For instance, a nominal interest rate of 10 percent may be advertised for a loan of 10,000 Norwegian Krone. This means that the NIR would be 1000 Norwegian krone. However, this is not the only loan cost.

The effective interest rate (EIR) does a better job of explaining the true cost of obtaining a loan. This is because it does not only factor in the base rate but other fees that are attached to securing the loan. In other words, the true cost of a line of credit is better reflected by it.

Compounding frequency.

Interest rates can be dynamic. This means that it may not be static in light of the loan agreement and other factors at work. The nominal interest rate is presented in a manner that suggests that it is static and not dynamic.

In the investment context, this type is mostly presented for annual reports. However, it can equally be used for lesser time frames.

On the contrary, an effective interest rate takes the dynamic nature of loan costs into account. As a result, a more accurate figure of the loan’s cost over time is presented. For this reason, borrowers should learn to calculate the cost of a loan they are considering or have secured using the effective type. This is rather than the nominal type. Speaking of how both are calculated, the next point addresses this.

How they are calculated?

The nominal interest rate is a lot easier to figure out because no calculation is required. It is just as advertised by the lender. This is not how things work with an effective interest rate. You need to do some calculations. This is because of compounding frequency as influenced by loan duration, inflation (in some cases), and other factors.

There is a proven formula for arriving at the effective interest rate of a loan.

That formula is as shown below:

(1 + i/n)n – 1

“N” in the equation represents the amount of compounding periods in a given year. The “I” which is to be divided by “N” represents the stated annual interest rate.

Fortunately, some special online calculators can be used to calculate this. So, you may not have to go through the trouble of doing this calculation yourself. Having a finance expert do the calculations is also an option that can be considered.

Making informed financial decisions.

The EIR helps people make informed financial decisions by seeing the true cost of a loan or the worth of an investment. As a result, people can make educated choices.

The NIR can be misleading. This is because it is simply the base rate and does not factor in other fees that come with the loan. That includes compounding fees. In light of this, your decision to take out a loan or invest in any venture should be informed by the effective interest rate.

Why do lenders include interest rates?

Lenders include these rates in the loans they offer borrowers because:

It is how creditors make their profit.

Creditors are in the business of granting loans to borrowers. Just like any business that sells a product will not sell at the cost price but would include interest, the same applies to creditors. They sell the financial service of offering loans. As a business, they include this fee to generate revenue and stay in business.

This is one of the major ways that creditors make a living and run their business operations. Another way is investing saved funds in profitable ventures.

To make up for the risks involved.

There are risks in the business of lending people money. There is a chance that the borrower cannot or will not pay back the loan. Interest rates are added to cover this risk. For example, many people who use Payday loans default.

However, the high-interest rate charged to other borrowers can make up for the damage caused by those who default. This is not forgetting that there are financial penalties for not repaying the debt on time.

On the whole, risk is a major factor in deciding how much borrowers have to pay in addition to the borrowed principal. For instance, prospective borrowers with low or bad credit scores are usually given loans with high-interest rates. This is because the risk involved in granting the line of credit is higher.

In the same vein, unsecured loans usually come with higher rates. This is because there is no collateral that the lender can hold onto if the borrower defaults. On the other hand, secured lines of credit usually have a lower rate, seeing how a worthy asset is offered as collateral.

For protection against inflation.

Money is not likely to retain its value over time, and that explains what inflation and deflation are. The truth is that inflation, which is the rate at which the prices of products and services rise, is more of a reality than deflation, which is the opposite.

So, it is included to cover the effects of inflation that may set in on the granted loan. Some rates are even structured in such a way that they are directly influenced by inflation or deflation.

Operational and administrative costs.

As mentioned earlier, creditors run a business and they need money to cover operational and administrative costs. This additional fee that comes with the loan secured by borrowers is one of the ways this is possible.

Interest rates can be influenced by regulatory bodies.

Interest rates can be influenced by government fiscal policies. This is how it works in a lot of places. For example, the fiscal central regulatory body can place caps on these fees added to the borrowed principal. This would limit the interest rate percentage that a lender can demand from its borrowers.

Denmark is a good example of a country that did this. For example, SMS loans cannot be granted with an APR exceeding 35 percent. This is to prevent borrowers from becoming victims of predatory lenders.

Besides this, there are other ways that regulatory bodies can be involved. An example is in Sweden and Norway where proper credit checks have to be carried out on borrowers by creditors.

On a final note.

It is not enough for borrowers to know the interest rate of a loan. Beyond this, they need to be aware of the differences between the effective and nominal interest rates as explained in this article. This information will enable them to understand the true impact of taking out a loan.

As a result, they will be able to make the right decision to decline the loan offer or accept it. If there is room for negotiation, people with this knowledge will be in a better position to negotiate.

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