By the term effective interest rate is meant the total credit costs stated as an annual interest rate on the loan amount. The effective interest rate is thus not the same as ordinary interest, but also includes other costs to give a good and clear picture of how much the loan costs in total.
The effective interest rate takes into account all costs incurred in connection with the loan you obtain. Examples of things that are included are interest, surcharges, fees, setup costs, etc. Thus, simply all the costs that can be deducted from the loan.
When is effective interest rate a good measure?
Effective interest rates are a measure that fits very well on loans that are of the longer kind and then we talk about a year or more. For example, if you compare a private loan or mortgage that lasts for many years, the effective interest rate gives a very good overview of which loan is the cheapest to apply for.
Do not forget that the effective interest rate is affected by interest and fees, etc. You must therefore compare two loans that are as equal as possible for it to be fair. If there are not two equivalent loans, it does not say much what the effective interest rate will be.
When does it not fit with effective interest rates?
First, it should be clear that surveys have shown that 66% of people do not know what effective interest rates mean. Given this, therefore, it may not be a very good measure to help people understand which loan is the cheapest. For example, the Consumer Agency has chosen to recommend that the banks present the total cost of a loan not only in effective interest rates but also in USD.
The effective interest rate is also not particularly interesting when it comes to short micro loans such as SMS loans. Since these loans are so short and normally should be repaid after 30 – 90 days, the cost of repaying for a full year is not important. For this type of loan, one can come up with effective interest rates of several hundred percent and sometimes over a thousand percent. However, it should be said that effective interest rates can be used to compare two identical micro loans, but do not compare a micro loan with a private loan.
Instead, it is usually more interesting to know what the loan really costs in USD. It says a little more if you know that for example it costs USD 300 at one place USD 250 at another place to borrow USD 1,000. If you know, you can easily compare which micro loan is best for you. All lenders offering their customers micro loans print what their loan costs. So this is probably easiest to compare and this is also how we compare the different lenders here on the site.