The first thing we have to do to establish the meaning of effective rate is to determine the etymological origin of the words that make up the term. Thus, in the first place, we can state what rate comes from the Latin verb taxare, which can be translated as "set a maximum price".
Second, effective also comes from Latin. Specifically emanates from the word effectivus which comes to mean "that carries out something".
The relationship between two magnitudes is known as rate and expresses the relationship between a quantity and the frequency of a given phenomenon. He interest On the other hand, it is the value, utility, profit or profit of something.
These two concepts allow us to approach the notion of interest rate , which is the price of money that is paid or charged to request or assign it for a certain period. The nominal interest rate It is one that reflects the profitability or cost of a financial product periodically.
The effective rate instead, it indicates the rate at which the capital . As interest capitalization occurs a certain number of times per year, an effective rate greater than the nominal rate is obtained. The effective rate, on the other hand, includes the payment of interest, taxes, commissions and other expenses related to the financial operation.
When calculating the effective rate, a series of fundamental elements must be taken into account. Specifically, it is necessary to have data such as the number of disbursements, the time that has elapsed between the start date and the disbursement date, the number of payments, the nominal interest, the charges, the commissions, the disbursement amount and also the value of the fee. With this last term we refer to both interest and amortization, commissions and other series of charges that may exist.
If, on the contrary, what we want is to carry out the calculation of the annualized effective rate, the process is much simpler. The formula for doing so would be the following: ie = (1 + ik) k - 1.
In this formula the established elements correspond to the following concepts: ie is the annualized effective rate; ik is the effective interest rate that refers to the payment time of the quota in question, and finally k is the number of installments that exist per year.
If we have an interest rate of 2% per month, it could be said that the nominal rate is 6% per quarter (2% monthly for three months). This rate, therefore, does not take into account the value of money over time. The effective rate, on the other hand, also considers the capitalization of money.
The nominal rate is usually referred to a period of one year, although it involves several interest payments within that period. The effective rate, on the other hand, only measures the performance in the period in which the payment or collection is made.