Nominal vs effective interest rate

Since banks have to make a profit, they do not lend their money for nothing. That is why interest is charged periodically. The amount of the interest depends on the creditworthiness of the borrower and the amount borrowed.

Effective interest rate

The monthly interest does not provide a good picture of the total costs that the consumer is charged monthly or annually as a result of the credit, which can easily lead to confusion. The effective annual interest rate is a figure that expresses the total costs of a loan much better than, for example, the monthly interest due. The effective annual interest rate includes all credit charges. If the effective annual interest rate is on the high side compared to the monthly interest rate, this indicates relatively high additional costs.

Variable interest rate vs fixed interest rate

Loans can be taken out at a variable interest rate or at a fixed interest rate . Both options have advantages and disadvantages: the longer the fixed interest period, the higher the effective interest rate. If the interest rate is variable, the debtor may, on the other hand, be exposed to extreme interest rate fluctuations, which is not recommended, especially for long-term loans. The interest rate risk can still be limited by agreeing on an interest rate cap (upper limit) for the debtor, but this will of course incur additional costs. There are often large differences in the mortgage interest rates charged by banks. A careful comparison can save thousands of euros. You choose a fixed interest period based on the interest rate expectation. But which factors determine interest rate expectations for mortgages?

Nominal interest rate

The interest rate that lenders advertise is usually the nominal interest rate . This is also the interest rate as stated in your mortgage deed. But when does that interest expire? Is payment per month, quarter or year? And is this a payment in advance or afterwards? In addition, taking out a mortgage is associated with additional costs such as closing costs and insurance.

Effective interest rate

If all additional costs are taken into account and also the time at which payment is made, we call it the effective interest rate. Pursuant to an EU directive, lenders have been obliged since 1998 to also state the effective interest rate for all loans under 50,000 euros. Consumer organizations believe that this makes credit offers more comparable. Unfortunately, this obligation does not apply to mortgages. Credit advertisements therefore now state the effective interest rate (often in small print) in addition to the nominal interest rate. So if you want to compare a personal loan or revolving credit reliably, you must note the effective interest rate. This is the only way you know who charges the lowest interest rate.

Calculation of effective interest for mortgages

And how do you do that for mortgages where no effective interest rate needs to be stated? Well, then you’ll have to do it yourself. A rough calculation is as follows:

  • Divide the nominal percentage by the number of times per year that you pay interest;
  • Add 1 to that;
  • You raise the result to the nth power, where “n” is the number of payment periods;
  • Subtract 1 again from the result and you have the effective interest rate.

Small corrections may be necessary if interest is due in advance or afterwards. Also of influence is the question of whether the year has 360 interest days or 365, matters that you can find in the loan agreement. Either way, always let interest work to your advantage.

The main interest rate

Monetary policy must be guided to some extent. For this reason, the European Central Bank periodically sets so-called target rates. Banks and credit institutions have the option to exchange collateral or securities for money at their central bank at those interest rates. In this way, the ECB’s target rates also affect loans that ordinary customers take out from their bank.

Savings and investments

Although this article focuses on the interest and cost aspects of loans, the distinction between nominal versus effective interest obviously applies equally to the return on savings and investments.