A borrower who is considering loans from several different banks with different terms and fees must compare the effective interest cost of each loan to decide which is the most cost-effective. The rate quoted by a lender does not give an accurate picture of the effective costs and rate of the loan, which depends on other charges associated with the loan and how the lender calculates interest.
Compounding affects the effective interest costs of a loan. Computing the interest rate not annually but based on a different period, such as quarterly, changes the effective costs and rate. If a business borrows $10,000 at 10 percent with interest compounded annually, the company would pay back $11,000, or the original amount plus 10 percent interest. By compounding quarterly, the bank would add 2.5 percent each quarter to the loan amount. So, the bank would add $250 in interest for the first quarter and $256.25 for the second, charging interest on the interest from the first quarter. At the end of the term, the business would pay back $11,038.19, for an effective rate of 10.38 percent.
Up Front Costs
Application fees and other prepaid fees change the effective interest costs and rates of a loan. If a bank requires an application fee of $300, this fee is an effective interest cost, as the borrower only receives a net of $9,700 from this loan. The bank will charge interest on the full $10,000 amount, so on a 10 percent loan compounded annually, the interest charge would be $1,000 plus the application fee, for an effective rate of 10.31 percent.
Some loans, such as home mortgages and business loans, realize an income tax benefit because of tax-deductible interest. Consider this when calculating effective interest costs. If a business borrows $100,000 at 10 percent for one year compounded annually, the company will pay $10,000 in interest. If this interest is fully tax-deductible, and the taxpayer has a nominal income tax rate of 25 percent, he will save $2,500 in taxes from the interest. This makes the effective interest cost of the loan $7,500 and reduces the effective rate to 7.5 percent.
Potential tax savings on loan interest must be evaluated carefully. In 2011, a married person filing jointly could claim a $11,600 standard deduction from his income without itemizing deductions. If he takes out a mortgage with $10,000 in annual interest costs, and he pays $3,000 in property taxes with no other itemized deductions, he would only see an increase in deductions of $1,400, or the amount that the mortgage interest increases his itemized deductions over the standard deduction amount. Not accounting for the standard deduction could cause a person to overstate the positive impact of tax deductions on his interest rate.
- Dummies.com; Nominal and Effective Interest Rates for Business Loans; John Tracy
- Brigham Young University: Personal Finance: Calculating Effective Interest Rate
- Bankrate.com; Paying for a Swimming Pool; Jenny C. McCune; July 2002
- IRS.gov: Many Tax Benefits Increase Slightly Due to Inflation Adjustments
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