A periodic interest rate is a rate charged on a loan over a certain number of periods. Lenders often attach interest rates on an annual basis but it is uncommon. The commonest is the interest compound. Mathematically, the periodic interest rate is the annual interest rate divided by the number of compounding periods. The more the compounding periods (monthly), the more the interest yielded.
The number of compounding periods has a direct effect on the periodic interest rate of a loan. Theoretically, if you have a loan with a periodic rate of 1%, its effective annual return will be 12% if scheduled every month. The periodic interest rate is 0.00033, but if the periodic rate is daily, it will be 0.03%.
We can say that the often an investment compound can be, the more quickly it grows. For instance, if a loan of $1,000 was lent for an investment placed under two options. If one investor should operate on an 8% annual interest rate and its interest compounds monthly for ten years and the second person operates with an 8.125% interest rate and compounds annually for the same 10 years. What will be the periodic interest rate?
The first investor by the end of 10 year period will grow the $1,000 to 2,219.64, but the second investor will grow by $2,184.04. This is to derive what the first statement of the paragraph is trying to talk about. Even at a greater interest rate, the second investor made lesser because of the compounding periods. This is why lenders make use of the monthly compounding rate.
WHAT YOU SHOULD KNOW
- Firstly, do you know that lenders prefer the interest compounding to be frequent (monthly) compared to annual interest compounds?
- Also, do you know that interest on mortgage compounds monthly?
- Do you know that Credit card lenders calculate interest based on a daily periodic rate? However, the interest rate is then multiplied by the remaining amount the borrower owes by the end of every day.
Types of Interest Rates
The annual interest rate:
this is the rate placed on loans before the compounding has been taken into account. It is regarded as a nominal interest rate. The effective interest rate is determined after the compounding has been included in the calculation. Thus, you should be aware of the compounding periods and the nominal rate of the loan to be able to calculate the effective annual interest rate.
Knowing the figures of the nominal annual interest and compounding period, you can now divide the nominal rate by the number of compounding periods. However, the result is the periodic interest rate.
To get the effective interest rate, add the result to 1 and take the sun by the power of the compounding interest rates. Finally, subtract 1 from the product.
Daily periodic rate:
a typical example is a credit card lender. The interest rate for a credit card is calculated on the daily periodic rate. The interest rate is multiplied by the amount the borrower owes at the end of each day. It will be recorded to the day’s balance and then another cycle happens again. So you can now determine the daily periodic rate by dividing the APR by 365 or divide by 360 compounding rate often used by some lenders.
Some revolving loans consider borrowers from accumulating interest, allowing borrowers to pay off their balances by a certain date within the billing cycle without further interest compounding on their balances.