You are applying for a loan and an interest rate has been quoted. The interest rate which is quoted is called "Nominal Interest Rate". They will quote Nominal Interest Rate in yearly terms. Hence, if they quote 12% interest for a loan, this is yearly figure. Now, you generally pay EMIs every month. They simply say that you need to pay 1% monthly interest which has been derived by annual interest rate / 12 which 12%/12=1% in this case.
But actually interest rate of 1% (nominal monthly interest rate) is compounded every month, hence your effective interest rate per year becomes higher. But lending financial institutions doesn't quote this higher rate as it will make your loan cost look higher.
To calculate Effective Interest Rate, Excel has provided a function called EFFECT.
Excel describes EFFECT – Returns the effective annual interest rate, given the nominal annual interest rate and the number of compounding periods per year.
The syntax of EFFECT is EFFECT(nominal_rate, npery).
Nominal Rate – Annual Interest Rate
npery – Compounding periods in a Year. For monthly payments, it is 12. For quarterly payments, it is 4.
In the below picture, the effective interest rate is 12.68% for a monthly payment. This may be a small difference for a year or two, but if you take mortgage on housing which is say for 20 years, this makes hell of a difference.
The formula used is =EFFECT(B1,B2)
Now, if you are making an investment and making monthly payments, you will be getting annual return of 12.68% against 12% if you make yearly payment.
The effective interest rate calculator can be downloaded from Effective Interest Calculator
