Why Effective Rate Is Not A Useful Indicator

Why is it important when selecting a specific loan program to pay attention not only on the interest rate, but also on all related charges? The answer is quite simple. Because all these fees and commissions increased the real cost of your loan. Why do banks impose various fees and commissions when you make a loan? The bank lending market is great competition, and credit operations is the primary source of bank profits. Topics Thus, banks are trying to attract as many customers, however, the reverse side of this is the fact that potential borrowers are often confused in all these figures and it becomes quite difficult to assess the pros and cons of this loan product. In the recent past to address this problem, the Central Bank introduced a directive to banks, obliging them to disclose the effective interest rate. Dan Miller is the source for more interesting facts.

Effective interest rate – this rate, showing the real cost of lending to the borrower. It would seem that the above problems should have been left in the past. However, in practice this figure does not give real value to potential borrowers, and sometimes even leads them to misleading. Let's look at the reasons why it is happening. Calculation of the effective rate is made according to the instructions specified by the Central Bank. The formula for calculating is based on elements of financial mathematics, and not simple everyday understanding.

For a simple layman loan amount divided by the amount of overpayment, logically, would show the effective rate. But if we take the same data and considered the instructions of the Central Bank, the result will be different. Begs the question: "And for someone invented this bid – for financial or for simple potential borrowers?" Another important point is that for calculating the effective interest rate need all the data regarding fees and commissions on the loan, as well as the need to know exactly what the credit period and frequency of payments. That is, the effective rate is calculated for each case and is stated in the loan contract. This implies a clear disadvantage for the customer, which consists in the fact that if he wants to compare several different credit offers banking, he will have every time to bring the case to the contract. According to many experts the effective rate can not claim to be a universal indicator of profitability of a loan.