When a lender lends money to a borrower, the lender charges interest. This is, so to speak, 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 referred to as the nominal rate. For comparing loans, the nominal rate alone is not suitable; the effective interest rate is relevant.
Interest rate – Introduction
People who take out a loan receive a certain sum of money from a bank or from a private lender paid out at a set loan interest rate. They must either repay this amount in small installments, which include the cost of the loan interest rate, over a longer period of time, or they must settle the total loan amount at a fixed agreed date. In the following guide we explain the difference between the nominal rate and the effective annual rate and provide examples of interest calculations.
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 loans can also be necessary for other major purchases. Buying a new car, a costly renovation at your home, or another large expense can also make a loan necessary.
In many cases, loans are already helpful for smaller purchases, since the needed items are available immediately and the customer does not have to save up for a long time to buy them. A loan is often very helpful, but it always has its price.
To make the loan amount available, banks charge a loan interest rate. This means that the customer must not only repay the loan but will always incur somewhat higher payments to cover the bank's services. The loan interest rate can be stated in different ways.
Types of interest
While the interest rate is stated as a percentage, the interest amount is the concrete value of a sum that is charged as a fee for borrowing a loan. The interest rate can also be influenced by compound interest.
The term compound interest refers in practice to the reinvestment of interest, which is added to the borrowed capital. Mathematics distinguishes between linear interest and exponential interest. The contract must clearly state which of these calculation methods is being used.
Another component of the interest rate can be the term structure, which depends on the duration of the loan granted. When financial advisors speak of the nominal rate, they mean the rate stated in concrete numbers that is due for a desired loan amount.
If the financial advisor talks about the real interest rate, they mean the rate after deducting the current inflation rate. For this reason, the real rate can in some cases be negative, namely when the inflation rate exceeds the nominal rate.
When the term effective interest rate is used, it refers to the rate that results when the nominal rate is considered in relation to other price-determining factors.
The phenomenon of a nominally negative interest rate is rare and usually only becomes possible in times such as a financial crisis.
The money market rate is also a form of interest rate. It is used to denote the rate for obtaining cash on the national or international money market. This money market rate is especially important for transactions between individual credit institutions. The money market rate between the credit institutions and the central bank is referred to as the policy rate. The interest rate for the capital market, which is important for bank lending with long maturities, is also called the capital market rate.
Interest rate for MAXDA loans
Are you looking for a reputable loan? Are you 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 the individually best interest rate!
Deriving the effective rate from the nominal rate
The nominal rate is the pure debt interest. With it, a fixed sum for the loan costs can be calculated. In an example for interest calculation, the relationship between the different interest components can be illustrated simply:
For a loan amount of 6,000 euros, 5% interest and a term of 60 months, that is 1,500 euros. However, that does not capture all the loan costs. The incidental costs of a loan consist of commissions and completion fees.
Assuming incidental costs of a total of 500 euros, the loan costs of the example loan above rise from 1,500 euros to 2,000 euros. If you now 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 interest is called the effective interest rate, because not only the pure interest calculation is taken into account but also commissions and fees are included.
When comparing different loans it is only the effective interest rate that is suitable as a comparison criterion. The legislator has made the disclosure of the effective interest rate mandatory.
Nominal rate level depends on several factors
There are various criteria that influence the loan interest rate. The European Central Bank's policy rate is only one factor. It determines the rate at which the bank itself can obtain capital. The bank does not lend its own money but borrows it there itself.
The bank adds its profit margin to this rate. In addition, it estimates the development of inflation. During the term of the loan the sum 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 sum after repayment is at least as high as at the start of the loan.
Another surcharge is added for the expected risk on the interest. The risk for the bank lies in a failure to repay 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 bank will set the risk surcharge.
The last factor is the security for the loan. If an asset with lasting value is used as collateral, such as a property, the interest rate will be moderate. If the loan is intended for a consumer good or pure consumption and the security consists solely of proof of monthly income, the interest will be correspondingly higher.
The nominal loan interest rate
Calculating a loan interest rate (interest calculation) is common in financial transactions. If a customer, for example, deposits money in the bank, they receive interest for it. This is added to the starting capital. If, on the other hand, you borrow money from banks in the form of a loan, you have to pay interest for it.
If you receive interest on a savings balance, it is shown as credit interest. If you have to pay interest for a loan, this is called debit interest. The amount of interest or the rate of interest results from the amount on 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 rate
The interest rate or interest coefficient is expressed as a percentage and represents the monetary claim levied on borrowed capital. In financial literature the interest rate is equated with the letter i or p. However, the internationally more common notation i appears to be prevailing. Occasionally experts also distinguish between the term interest coefficient, denoted by the letter p, and the interest rate, which is then denoted by i.
If a distinction is made 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, which means that p = 100 x 5% = 100 x 0.05 = 5.
Interest is usually calculated once a year (simple interest). Here is an example. If you take out a loan of 10,000 euros at a loan interest rate of 5 percent, 500 euros are due after one year. However, most loans require monthly installments. In this case the loan interest rate is recalculated for each period.
If, for example, you repay 100 euros each month, after one month interest will only be calculated on a loan amount of 9,900 euros, after another month only on 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 on the amount actually borrowed at the respective time. The nominal loan interest rates can differ significantly between different offers. Therefore it is always important to compare the loan interest rates of the various offers carefully.
Usages in interest rate calculation
In finance the banking year is referred to as the usage (usance). To apply the interest formula correctly, the usance must be clarified. The German method is called 30/360, where the year is reduced to 360 days and each month always has 30 days.
The Euro method is referred to as act/360. Here the French usance is 360 days, but the actual days of the months are counted. The English method is called act/365, where the English usance has 365 days and the actual month days also 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 29 February is counted. On the European money market, act/360 is generally used and the first day of taking out the loan is not included in the interest rate calculation.
What is the effective annual rate?
With a loan not only interest is charged; there are many other fees. Many banks, for example, charge a processing fee and a loan fee. Interest-free years can also influence the actual price the customer has to pay for the loan. In addition, there are different methods of how repayments are credited, which also affect the final amount of payments. These additional costs mean that the nominal rate is only one of several factors responsible for the level of the monthly installments.
Therefore, consumers often find it difficult to compare different loans. A loan can therefore result in a higher actual burden than another loan, even though the nominal rate is actually lower. For this reason there is a law in Germany that obliges banks to state not only the nominal 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 rate
The legislator has also specified a procedure according to which the effective annual rate must be calculated. This standardized procedure (or standardized formula; interest calculation) is intended to ensure that the effective annual 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 consumers to compare the effective annual rate. If a customer only compares the nominal rate, the loan costs can still show significant differences.
In a loan agreement the effective annual rate (shown as a percentage) is also mandatory (actual annual loan costs). If the data in a loan agreement have been calculated incorrectly and the values resulting from the fees and the nominal loan rate should be higher than the stated effective annual rate, the bank is always obliged to reduce the nominal loan rates so far that the agreed effective annual rate is complied with.
Conclusion: Compare loan interest rates quickly and easily
If you need a loan and want to compare the various offers, it is always sensible to pay first and foremost attention to the effective annual interest rate (expressed as a percentage). This allows you to assess the total cost of the loan at first glance. This helps you estimate how to manage your capital.
If you are looking for an affordable loan, it makes sense to use a loan calculator on the internet. This will show both the nominal rate and the effective annual rate. To keep the total costs low, it is always sensible here to choose the offer with the cheapest effective annual rate. An example of the calculation (formula, interest calculation) of the interest rate can be found above.
Glossary: Key terms on interest rates
Compound interest: In finance this denotes interest that is added (capitalized) to the capital (initial capital) and in future is subject to interest 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 assessed as a fixed percentage of the loan amount. The rule of thumb applies: 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 rate. The latter includes, in addition to the loan interest, the costs incurred – i.e., fees and commissions for the loan.
Daily interest: When interest must be calculated for a period shorter than a year, it is referred to as daily interest. Daily interest and overnight deposit interest are often confused. Overnight deposit interest refers to an overnight deposit account and is calculated annually. Daily interest, on the other hand, refers to a single day.