Understanding interest rates - Effective vs Simple

  • Funding Societies

    Are you confused by the different interest rates provided in the loansheet? Which figure should you follow? Do you need to pay attention to the processing fee and commissions? These are the questions I will tackle today. But first, a warning – interest rate can be a confusing topic, especially for those without a background in finance. I’ll try to keep things simple and use plenty of examples.

    Borrower’s interest rate refers to the interest rate paid by the borrower.

    Investor’s interest rate refers to the interest rate earned by an investor.


    Simple interest rate versus effective interest rate

    Simple and effective interest rates are different ways of calculating interest and repayment. Funding Societies prefer to use simple interest rate, while MoolahSense and Capital Match use effective interest rate.

    Simple interest rate computes interest payments based on the initial amount lent out (called the principal).

    Effective interest rate computes interest payments based on the outstanding principal and the end of each term.

    Funding Societies Example

    (A) Simple interest rate, paid by the borrower.
    (B) Effective interest rate, paid by the borrower.
    (C) Net simple interest rate, earned by the investor.
    (D) Net effective interest rate, earned by the investor.
    (E) Principal Repayment (per month) = $200,000 / 12 = $16,666.67
    (F) Interest Repayment (per month) = $200,000 x 13% / 12 mths = $2,166.67
    (F) Service fee (per month), paid by investor = ($16,666.67 + $ 2,166.67) x 1% = $188.33
    (H) Monthly repayment received by investors (net of all fees) = $16,666.77 + $2,166.67 – $188.33 = $18,645.00

    As an investor, you want to compare the investor’s net effective return across different loans and platforms. This is the return you will earn as an investor on each dollar invested, net of all fees.

    This article was originally published on Letscrowdsmarter. Link to the original article: http://letscrowdsmarter.com/understanding-interest-rates/

  • Contributor

    wow.. this is quite helpful.

  • What's the formula to calculate the Effective Interest Rate? I still don't get the compounding effect and the explanation given on how to calculate the effective interest rate. Thank you.

  • Funding Societies

    The effective interest rate is calculated through a simple formula: r = (1 + i/n)^n - 1.
    In this formula, r represents the effective interest rate, i represents the stated interest rate, and n represents the number of compounding periods per year.

    The compounding effect is something which you yourself can create by reinvesting your earnings.

    For example, if you start with 100RM, and earn 12% interest after investing it. Now, if you don't withdraw your funds, but reinvest the whole 112RM into a new loan, with 12% interest, you earn 125RM.
    So, in total, you have earned 25% earning on your initial investment of 100RM, even though the loans you chose to invest only have a 12% simple interest rate. So, the effective interest rate you earned is 25%.

    Hope this helps.

    See this for a more detailed explanation of how you can achieve effective interest.

  • Dear Vamsi and admin,

    Can you show how to get effective interest rate of 21.23% based on the example above?



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