Effective interest rate

What it means

The effective interest rate is the actual annual cost of a loan or return on a deposit, taking into account compounding frequency and fees, not just the nominal rate. A loan at a nominal 6 percent with monthly compounding and an arrangement fee actually costs more than 6 percent a year.

The difference arises with compound interest: the more often interest is credited, the more interest is earned on earlier interest. With simple interest and no fees, the effective and nominal rates are equal.

For consumer loans, the equivalent is the APRC, the annual percentage rate of charge that lenders must disclose so loans can be compared. For business loans, the effective rate is used mainly to compare offers internally and in IFRS accounting.

How it works in practice

When comparing bank offers for an investment loan, include the arrangement fee, loan account charges, compulsory insurance and the cost of collateral. A lower nominal rate with high fees can be more expensive than a higher rate with no fees.

Under IFRS 9, financial liabilities and receivables are measured at amortised cost using the effective interest method. Fees and discounts are spread over the life of the loan instead of being booked to expenses or income at once.

Slovak accounting procedures are simpler for most companies, and loan fees are often expensed immediately or deferred on a straight-line basis. Differences can therefore arise against a group's IFRS accounts, which must be adjusted on consolidation.

What to watch out for

The effective rate holds only if the loan terms are kept. Early repayment, a change after the fixed-rate period ends or penalty interest on late payment change the real cost, so the terms for early repayment and re-fixing should be read too.

For deposits and investments, banks sometimes highlight a high rate for a short period or only part of the deposit. What matters is the annual return you actually receive after fees and taxes over the whole period, not the rate in the advert.