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Effective Annual Interest Rate
Effective annual interest rate is also called annual percentage rate(APR), if you are a borrower. If you are an investor, it is called annual percentage yield (APY) The compounding of the effective annual interest can be monthly, quarterly, semi-annually, and annually. The formula for the effective annual interest rate is the same to that of the APY: C(1 + i)n -1. For instance, if an effective annual rate for $1,000 is compounded annually, the amount will be $1,100 by the end of the year. However, if the compounding occurs monthly, $1,000 will turn into $1104.70 by the end of the year, giving the effective annual interest rate of 10.47% by the twelfth month even though it starts at 10% on the first four months.
The effective annual interest rate or the APR can be a confusing number even to investors. As a borrower, you cannot easily compare the APR from different lending institutions. They usually have their own way of calculating it. A good way to understand the effective annual interest rate for each bank is by asking them to provide you with a good-faith estimate of their cost on the same type of program, for instance a 30-year fixed rate.
The reason why APRs are confusing is because there are several fees that can be included in the APR. Some of the fees that are included in the APR are points, pre-paid interest, loan-processing fee, underwriting fee, document-preparation fee, and private mortgage insurance. There are other fees that are not normally included in the APR. These fees are title fee, escrow fee, attorney fee, notary fee, home-inspection fee, recording fee, and appraisal fee. So you may want to check with your lender on what fees are specially included in the APR
The effective interest rate is important to borrowers because there is a huge difference when between the compounding that occurs annually and monthly for a loan that is to be payoff in 20-30 years. Consumers need to be aware, and in some countries, they require lending institutions to disclose the effective interest rate, which is commonly known as annual interest rate.
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