Effective Annual Interest Rate

Effective annual interest rates are important figures in lending and borrowing. They should not be confused with nominal interest rates.

In Switzerland, effective annual interest rates are most commonly used in relation to consumer loans. They provide a uniform criteria for the comparison of loan offers by potential borrowers.

An effective annual interest rate is an annual figure, as its name implies. It indicates the interest applicable over one year, regardless of the time frame in question.

Calculating effective annual interest

Several different methods can be used to calculate effective annual interest rates. The uniform method is a simple method of calculating effective annual interest rates.

Effective annual interest rate as a percentage = 100 * (loan costs / loan amount) * (24 / (term in months + 1))

This method of calculation does not account for the timing of repayments, nor does it take the compounding interest effect into account. However, because the method is simple to use and understand, it is often used to estimate effective annual interest rates.

In European Union member countries, the internal rate of return (IRR) method is more commonly used. This method is used in Switzerland as well. The effective annual interest rates of Swiss personal loans which fall under the Swiss Consumer Credit Act must be calculated using the internal rate of return method. In this case, the effective annual interest rate for the borrower is identical to the internal rate of return for the lender, with the borrowers expense matching the lenders profit.

This method allows for calculations of effective annual interest rates which take increases and decreases in loan principal and the timing of these changes into account. Factors which can be accounted for include the loan paid out by the lender (as a lump-sum or in installments). Amortization payments and interest payments made by the borrower and the payment of additional costs (such as administrative fees) and the timing of these payments can all be accounted for.

Example: Loan costs based on loan terms

A loan with 10,000 francs of principal must be repaid via 12 identical monthly repayments which must be paid at the end of every month throughout the term. If the effective annual interest rate were 9%, the loan would cost 474.80 francs.

If the same loan with the same 9% effective annual interest rate were repaid over a 24-month term, the loan would cost 926.00 francs.

In this case, doubling the term of a loan with a constant effective annual interest rate nearly doubled the loan cost. You can easily replicate this example using the moneyland.ch loan calculator.

The timing of repayments also plays an important role. The earlier repayments are made, the lower the cost of the loan are.

The reason for this is the way in which interest is calculated, which takes the following circumstance into account: the earlier a repayment is due, the sooner the lender can reinvest that money and therefore the more valuable that repayment is to the lender. The result is that two different loans with identical loan amounts, effective annual interest rates and loan terms but with different loan repayment schedules may have different total costs.

Example: Credit costs dependent on repayment schedules

A loan of 10,000 francs with a loan term of 6 years is offered with an effective annual interest rate of 10%. If the loan were repaid using a single, lump-sum payment at the end of the loan term, the amount owed would come to 17,715.60 based on the internal rate of return calculation method. The total cost of the loan would be 7715.60 francs (17,715.60 francs – 10,000 francs).

If, on the other hand, the loan is repaid using two identical repayments of 7600 francs each – one after 3 years and the other after 6 years – the cost of the loan would be just 5200 francs (2*7600 francs – 10,000 francs).

You can determine how high your repayments are if you know the loan amount, effective annual interest rate and loan term, and as long as repayments are identical in size and you know the number and timing of repayments across the loan term. If the size and timing of costs is subject to change, the term “initial interest rate” is used. If changes which affect cost change in the future, the initial effective annual interest rate will adjust to accommodate these changes.

Effective annual interest rates and Swiss personal loans

In Switzerland, the effective annual interest rate is the standard cost indicator for personal loans, leasing, and credit cards. Up until July 1, 2016, the maximum effective interest rate which could be used for Swiss personal loans was 15 percent. An addition to the Swiss Consumer Credit Act which took effect at that time stipulates that maximum effective annual interest rates will be adjusted to match the overall interest environment on an annual basis.

Cash loans which fall under the Swiss Consumer Credit Act must be repaid in identical installments. Typically, repayments must be made on a monthly basis. The lower the effective annual interest rate, the more affordable the corresponding loan is.

In the case of Swiss personal loans, you can use the loan calculator to easily find the effective annual interest rate, loan cost (monthly repayment), loan amount or term of a loan based on its other components.

Effective interest rate vs. nominal interest rate

The nominal interest rate shows interest as a percentage of a nominal value. It is normally based on a one-year period. But even when two loans have identical nominal interest rates, the actual amount of interest owed can differ depending on how interest is calculated (if interest compounding intervals or day-count conventions are different, for example).

If a loan has additional costs above the nominal interest or if its interest compounding intervals are shorter than one year, the effective annual interest rate is higher than the nominal annual interest rate. If there are no additional costs or intra-year interest compounding intervals, the effective annual interest rate will match the nominal annual interest rate. You can use the effective vs. nominal annual interest rate calculator to confirm this. Nominal interest can only exceed effective annual interest when the term is longer than 1 year.

Effective annual interest rates include possible hidden costs because they are calculated based on the actual outstanding debt and account for amortization payments. Because of this, effective annual interest rates are better suited to comparing the cost of loans than nominal interest rates.

More on this topic:
Calculator: effective interest vs. nominal interest
Loan cost calculator
Unbiased loan comparison
Tips for potential borrowers

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