If you ever want to make a banker blush, ask them what the effective interest rate is on your investments. A little known secret in the financial industry is that there are two main interest rates that clients receive and unfortunately, you may not be receiving the one that you think that you are. The good news is that you may be benefitting from this. These two interest rates are called; the annual and effective interest rates. This is one of those little details that banks keep secret, but is very important to understand.
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What is the Effective Interest Rate and How Can it Benefit You?
Let’s start with a small story, you walk into a bank with a $10,000 cheque and deposit it into a savings account that pays an annual interest rate of 3% and pays monthly interest. After a full year you come back in and walk out with $10,304.16. While this extra $4.16 may not make you think twice, but you received 3.04% instead of the quoted 3%. So what gives?
The simple answer is that quoted interest rates do not include compounding interest (interest that builds on past interest), while the effective interest rate does include compounding interest. So you end up earning extra money and in effect, a higher interest rate. The effective interest rate will also have a greater impact when interest rates are high.
Any investment that reinvests its interest into itself more than once a year will offer a higher effective interest rate. Savings accounts, some mutual funds and other investments will offer this benefit. Investments like GICs and stocks (that do not re-invest dividends) usually only offer an annual interest rate.
So overall, the type of investment that you choose can change the interest rate that you receive.
How the Effective Interest Rate Can Negatively Affect You
Unfortunately, the effective interest rate can also negatively affect you. If you have a loan or other credit product and not paying off at least the accrued interest for each compounding period (typically monthly, but check with your financial institution), then you’re paying an effective interest rate that is greater than the stated annual rate. For example, some student loans collect monthly interest, but do not require payments to be made until one year after graduation. So, if this loan is 6% and it compounds monthly, then your effective rate is 6.17%.
Credit cards can also further affect you if you do not pay the minimum amount. For example, if someone had a 19.99% credit card and made no payments at all, then the effective interest rate is 21.93%.
Overall, you need to pay off at least each compounding period’s interest to not pay a higher rate. To those feeling adventurous, you can determine an effective interest rate by using the following equation;
So that’s the basics on how effective interest rates affect you. For investments, try to find interest rates that compound frequently and for those with debt, remember to pay at least all of the accrued interest for each compounding period. Also, next time that you’re in a bank don’t forget to ask them what your effective interest rate is, you’re likely to receive an amusing response.
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