Before you take out a bank loan, you need to know how to calculate your interest rate and understand how to calculate it yourself.
Calculating Interest on a One-Year Loan
If you borrow $1000 from the bank for one year and need to pay $60 in interest for that year, then the advertised interest rate is 6%. Here is the calculation:
Effective rate on a simple interest loan = interest / principal = $60 / $1000 = 6%
The annual percentage rate or APR is the same as the advertised rate in this example because there is no compound interest to consider. This is a simple interest loan.
This loan becomes less favorable if you keep the money for a shorter period. For example, if you borrow $1000 from the bank for 120 days and the interest rate remains at 6%, the annual effective interest rate will be much higher.
Effective rate = interest / principal × Days in a year (360) / Days of the loan outstanding
Effective rate on a loan for less than one year = $60 / $1000 × 360/120 = 18%
The effective interest rate is 18% because you only have the use of the money for 120 days instead of 360 days.
Effective Interest Rate on Discount Loans
Some banks offer discount loans. Discount loans are loans where the interest payment is deducted from the principal before the loan is disbursed.
Effective rate on the discount loan = (interest × Days in a year (360) / Days of the loan outstanding) / (principal – interest)
Effective rate on the discount loan = (60 × 360/360) / (1000 – 60) = 6.38%
It can be observed that the effective interest rate is higher on the discount loan compared to the simple interest loan.
Effective Interest Rate with Compensating Balances
Some banks require small businesses applying for a bank loan to maintain a balance, known as a compensating balance, with the bank before they agree to grant the loan. This requirement makes the effective interest rate higher.
Effective rate with compensating balances (c) = interest / (1 – c)
Effective rate with compensating balances = 6% / (1 – 0.2) = 7.5% (if the compensating balances are 20%)
Effective Interest Rate on Installment Loans
Many consumers have installment loans, which are loans that are repaid with a set number of installments. Most car loans are installment loans, for example.
Unfortunately, one of the most obscure interest rates you will hear when talking about bank loans is the interest rates on installment loans. Interest rates on installment loans are generally the highest interest rates you will encounter. Using the previous example:
Effective rate on the installment loan = 2 × annual number of installments × interest / (total number of installments + 1) × principal
Effective rate on the installment loan = (2 × 12 × 60) / (13 × 1000) = 11.08%
The interest rate on this installment loan is 11.08%, compared to 7.5% on the loan with compensating balances.
Source: https://www.thebalancemoney.com/how-to-calculate-interest-rates-393165
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