When a lender lends money to a borrower, the lender charges interest. This is essentially the purchase price for the act of lending. The amount of interest is not agreed as a fixed sum but is calculated as a percentage of the amount of money borrowed. This interest rate on loans is called the nominal interest rate. For comparing loans, the nominal rate alone is not sufficient; instead the effective interest rate should be used.
Interest rate – Introduction
When people take out a loan, a bank or a private creditor pays out a certain amount of money at a fixed loan interest rate. This must either be repaid in small installments that include the cost of the loan interest rate over a longer period, or the total amount of the loan must be repaid at a fixed agreed date. In the following guide we explain the difference between the nominal interest rate and the effective annual interest rate and provide examples for interest calculation.
What is the loan interest rate?
A loan can be very helpful in many situations. Especially when buying or building a house, most people rely on a loan, but also for other major purchases. Buying a new car, an expensive renovation at your home, or another large expense may also make a loan necessary.
In many cases, loans are already helpful for smaller purchases because the required items are immediately available and the customer does not have to save for a long time to buy them. A loan is often very useful, but it always has a cost.
Banks charge a loan interest rate to provide the loan amount. This means that the customer not only has to repay the loan but also pays somewhat higher amounts to cover the bank's services. The loan interest rate can be stated in different ways.
For example, a costly renovation at your home: loan for renovation
Types of interest
While the interest rate is expressed as a percentage, the interest amount is the concrete value charged as the fee for a loan. The interest rate can also be influenced by compound interest.
The term compound interest refers in practice to the interest on interest that is added to the borrowed capital. In mathematics, a clear distinction is made between linear interest and exponential interest. The contract must clearly state which calculation method applies.
Another component of the interest rate can be the interest structure, which depends on the duration of the loan. When financial advisors speak of the nominal interest rate, they mean the interest rate given in concrete numbers that is due for a desired loan amount.
If the financial advisor refers to the real interest rate, they mean the rate after deducting the current inflation rate. Therefore, the real interest rate can sometimes even be negative if the inflation rate exceeds the nominal interest rate.
When referring to an effective interest rate, this denotes the rate that results when the nominal interest rate is considered in relation to other price-determining factors.
The phenomenon of a nominally negative interest rate is rare and typically only possible in times such as a financial crisis.
The money market interest rate is also a form of interest rate. It is used to name the rate for borrowing cash on the national or international money market. This money market rate is especially important for transactions between credit institutions. The money market rate between credit institutions and the central bank is known as the key interest rate. The interest rate for the capital market, which is important for long-term loans in book money, is also called the capital market interest rate.
Interest rate for MAXDA loans
Are you looking for a reputable loan? Interested in the interest rate for MAXDA loans?
Submit your loan request today without obligation and free of charge — you will then receive a loan offer with your individually best interest rate!
How the effective rate is derived from the nominal rate
The nominal rate is the pure debt interest. From it a fixed sum for the loan costs can be calculated. In an example for interest calculation the relationship between the different interest measures can be illustrated clearly:
For a loan amount of 6000 euros, 5% interest and a term of 60 months, that equals 1500 euros. However, this does not capture all loan costs. The ancillary costs of a loan consist of commissions and initiation fees.
Assuming ancillary costs of a total of 500 euros, the loan costs of the example loan above increase from 1500 euros to 2000 euros. If you convert these costs back into an interest rate, you get 6.67% instead of the original 5%. In this calculation all effectively incurred loan costs have been recorded. That is why this rate is called the effective interest rate, because not only the pure interest calculation is taken into account but also commissions and fees.
When comparing different loans, only the effective interest rate is suitable as a comparison criterion. The legislator has made it mandatory to disclose the effective interest rate.
Nominal rate level depends on several factors
There are various criteria that influence the nominal interest rate on loans. The key interest rate of the European Central Bank is only one factor. It determines at what rate the bank can obtain capital itself. The bank does not lend its own money but borrows it there.
The bank adds its profit margin to this rate. In addition, it estimates the development of inflation. During the loan term the amount loses purchasing power.
The bank also factors this loss of value due to inflation into the interest rate. It wants to receive enough money back so that the purchasing power of the amount after repayment is at least as high as at the beginning of the loan.
Another surcharge is added for the expected risk on the interest. The risk for the bank lies in non-repayment of the loan. To estimate this risk, the bank checks the borrower's creditworthiness, the so-called credit rating. The worse this is assessed, the higher the risk surcharge the bank will apply.
The final factor is the collateral for the loan. If a tangible asset with lasting value is used as collateral, for example a property, the interest rate will be moderate. If the loan is intended for a consumer good or pure consumption and the only collateral is proof of monthly income, the interest rate will be correspondingly higher.
The nominal loan interest rate
The calculation of a loan interest rate (interest calculation) is common in financial transactions. For example, when a customer deposits money at a bank, they receive interest for it. This is added to the initial capital. If, on the other hand, you borrow money from credit institutions in the form of a loan, you have to pay interest for it.
If you receive interest on a savings balance, this is listed as credit interest. If you have to pay interest on a loan, this is called debit interest. The amount of interest or the interest rate results from the amount for which the interest is charged and from the agreed interest rate. Below we give an example of an interest calculation.
Interest calculation: example for the nominal loan interest rate
The interest rate or interest coefficient is expressed as a percentage and represents the monetary claim demanded on borrowed capital. In financial literature the interest rate is either denoted by the letter i or p. However, the internationally more common designation i seems to prevail. At times experts also distinguish between the term interest coefficient, denoted by the letter p, and the interest rate, which then bears the designation i.
When distinguishing between interest coefficient and interest rate, the interest coefficient refers to the nominal value before the percent sign.
With an interest rate of 5% the interest coefficient would be p = 5. The interest rate i = p/100, for example i = 5% = 5/100 = 0.05, while the interest coefficient p = 100i, meaning p = 100 x 5% = 100 x 0.05 = 5.
Interest is usually calculated once per year (simple interest calculation). Here is an example. If you, for example, take out a loan of 10,000 euros at an interest rate of 5 percent, 500 euros are due after one year. For most loans, however, installments must be paid monthly. In that case the loan interest rate is recalculated for each period.
If you, for example, repay 100 euros each month, interest will only be calculated for a loan amount of 9,900 euros after one month, and after another month only for 9,800 euros. To enable this calculation (interest calculation), it is necessary to determine the loan interest rate for each individual day (daily interest).
This ensures that you only pay interest for the amount that is actually borrowed at the respective time. Nominal loan interest rates can differ significantly between different offers. Therefore it is always important to compare the loan interest rates of different offers carefully.
Usages in interest rate calculation
In finance, the banking year is called a convention. To apply the interest formula correctly, the convention must be clarified. The German method is called 30/360, where the year is reduced to 360 days and the month always has 30 days.
The euro method is referred to as act/360. Here the French convention has 360 days, but actual days are counted for the months. As the English method financiers use act/365, where the English convention has 365 days and the current month days apply. There is also the act/act method. Here both the current year and the month are based on actual days, which means that in a leap year a February 29 is counted. On the European money market the act/360 is generally used and the first day of the loan is not included in the interest calculation.
What is the effective annual interest rate?
Loans incur not only interest but also many other fees. Many banks, for example, charge a processing fee and a loan fee. Interest-free years can also affect the actual price the customer has to pay for the loan. In addition, there are different methods of how repayments are credited, which also influence the final amount of payments. These additional costs mean that the nominal interest rate is only one of several factors that determine the level of the monthly installments.
Therefore, consumers often find it difficult to compare different loans. For one loan the actual burden can be higher than for another loan even though the nominal interest rate is actually lower. Therefore, in Germany there is a law that obliges banks to state not only the nominal interest rate and the various processing fees in a loan agreement, but also the effective loan interest rate.
This indicates how high the total costs of the loan are and includes both the interest and all other fees.
Disclosure and calculation of the effective annual interest rate
The legislator has also specified a procedure by which the effective annual interest rate must be calculated. This uniform procedure (i.e. this standardized formula; interest calculation) is intended to guarantee that the effective annual interest rate is calculated in the same way by all banks and actually reflects the total costs of the loan. For this reason it is always more important for the consumer to compare the effective annual interest rate. If the customer only compares the nominal interest rate, the costs of the loan can still show significant differences.
In a loan agreement the effective annual interest rate (stated as a percentage) is also mandatory (actual loan costs per year). If the data in a loan agreement have been calculated incorrectly and the values resulting from the fees and the nominal loan interest rate should be higher than the stated effective annual interest rate, the bank is always obliged to reduce the nominal loan interest rates so far that the agreed effective annual interest rate is complied with.
Conclusion: Compare loan interest rates quickly and easily
If you need a loan and want to compare the different offers, it is always sensible to pay attention primarily to the effective annual interest rate (stated as a percentage). This allows you to assess the total cost of the loan at a glance. This way you can estimate how to manage your capital.
If you are looking for an affordable loan, it makes sense to use an online loan calculator. It will show both the nominal interest rate and the effective annual interest rate. To keep the total costs low, it is always advisable to choose the offer with the lower effective annual interest rate. An example of the calculation (formula, interest calculation) of the interest rate can be found above.
Glossary: important terms about interest rates
Compound interest: In finance, compound interest refers to interest that is added (capitalized) to the capital (initial capital) and in future is compounded together with the capital at the applicable interest rate.
Loan interest: Loan interest refers to the interest charged for a loan or credit. Interest is calculated as a fixed percentage of the loan amount. The rule of thumb is: the higher the loan amount, the higher the interest amounts. A distinction is made between the loan rate, the debit interest rate and the effective annual interest rate. The latter includes not only the loan interest but also the incurred costs — i.e. fees and commissions for the loan.
Daily interest: If interest must be calculated for a period shorter than a year, this is called daily interest. Daily interest and instant-access savings interest are often confused. Instant-access savings interest refers to an instant-access savings account and is calculated annually. Daily interest, on the other hand, refers truly to one day.