In the world of loans and finances, do you know what the most important facets to be aware of are? Well, really, there is just one critical thing. You guessed it – interest rates. They really are a huge part of what makes the world go ‘round in more ways than one. Not sure what I mean by that? Well, allow me a moment here to explain!
You see, there are several different types of interest, each of which work in a different manner. While you probably do not need to know each of the individual formulas and calculations for them, it never hurts to be better informed as to what they are and how they factor into your consumer loans.
Of course, that is not the only time that they will be relevant – most investments, checking accounts, and even savings accounts (as well as retirement funds) will involve this concept to some extent. So, if you would like to learn more about the different types of interest and what is involved with them, you have come to the right place!
Looking at the Big Picture…what is Interest?
I would be remiss in my duties if I did not first explain to anyone who is reading this what interest is in the broad sense of the word. Of course, I am speaking about it in the financial context of the phrase rather than anything else, so do bear that in mind as we continue. Consider checking out a page like this one, https://credit.org/blog/what-does-interest-rate-really-mean/, before you continue reading.
With that established, we can dive right on in. In essence, interest rates are what lenders charge borrowers during the overall loan process. After all, they do have to make money or profit somehow, right? Simply returning the principal amount that we borrow would not put anything extra into their pockets, and that is not a realistic way to run a business.
After all, at the end of the day, it is important to understand that financial institutions such as banks or other lenders are a business. So, they do need to create a stream of revenue, hence the existence of interest rates. What you are charged will be based upon a few factors, including how much the principal amount of your loan is.
There you have it – a basic rundown on interest. With that out of the way, we can shift our attention to some of the specific types. So, make sure to continue on to the next section for further details!
Nominal Interest Rates
The first in which I would like to take a more in-depth look at them is the “nominal” rate. You see, this is perhaps the simpler of the two that I will be focusing on today, but that does not mean that it is not important. Typically, when I lender is showing you what rate you will be charged, this is the one that they depict.
You see, when it comes to nominell og effektiv rente, the key thing that you should know is that the nominal ones are often shown as a simple percentage. This is largely so that consumers can know what they are looking for at a glance. That percentage can tell you a lot of what you need to know, thankfully.
In essence, it is the figure that demonstrates both the current rate and what is accounted for thanks to inflation rates. Right now, that is especially meaningful – when we look at our current state of affairs globally, there is certainly no denying that most of us are contending with some extreme rates of inflation across the board.
Your main takeaway here is that this is the fee that is advertised to you by lenders. When you are looking through a contract and checking out advertisements, this is what you will be seeing. Thankfully, it is accurate for the most part, but sometimes there are errors if the inflation ends up being different than what is projected. Just some things to keep in mind, of course.
Effective Interest Rate
Onto our next item on the docket: effective interest rates. These are sometimes referred to as “real” interest rates as well, if you were curious. You can find some further details on the distinction between the two of them here on this page, although I will be doing my best to explain this as well.
Effective interest rates are a bit different in that they take into account all of the potential extra costs and fees that could come into play with your rate. The main distinction here is that they look at the wholistic cost of the loan, so looking at it rather than the nominal figure can give you a bit of a better idea of what to expect as a whole.
Perhaps to some extent this feels like semantics – I certainly understand that feeling. It can be quite frustrating to realize that what we are advertised is not going to be exactly what we end up getting, and while that is true for a lot of parts of life, it feels especially irritating in the realm of finances. No one wants to find out that they are actually paying a lot more than they initially anticipated.
So, it does not hurt to ask the lenders that you are considering borrowing from what the effective interest rate will be versus the nominal one that they have listed. Personally, I find that it is a fairly big green flag when a lender already has that effective rate listed in the contract rather than making the consumer dig around for those answers.
Why Does Any of this Matter, anyway?
By now, I am sure that this question has been weighing pretty heavily on your mind. Why have I spent so much time discussing these two different types of interest? If they are sort of the same to some extent, and if one of them is pretty much always going to be the one that lenders advertise, why should we even bother to learn about both of them?
The answer there is pretty simple, thankfully – now that you are aware of them, you should pretty much always strive to compare them and determine whether this loan will truly be worth it in the long term thanks to the more realistic look at the costs. Honestly, while it may seem a bit pedantic to do so, you may be surprised by the results.
While I do not consider financial institutions and lenders to be “evil,” or somehow against us, I do think it is critical to understand that they are looking after their own best interests rather than ours. That is perfectly normal, really, and once we accept that, we can proceed as more well-informed consumers.
I am sure you can understand why I place such high importance on this as someone who is a frequent shopper and likes to explore the various credit agreements that I can take advantage of. Something that a lot of folks seem to forget is that even a credit card can end up having interest rates – so, if that is the case, it does not hurt to ask for those effective figures rather than just seeing the nominal ones.
Once you do start doing so, I can assure you that you will not regret it. After all, who does not want to get a better deal or even just a more accurate representation and expectation for what we are going to be paying in the future? It helps us do a few things with a bit more ease in terms of our financial planning.
How can we accurately predict and create a plan for repayment of a loan if we are not sure all of the fees that are involved, right? Yet it remains a huge part of the application process – a lot of the time, lenders will even want to know details about your life such as how much you make in a month and how much of your paychecks go towards rent. This is to get a gauge of how responsible you are with money and whether you will be able to take on additional costs.
Yet, without that effective interest rate, we cannot accurately predict this. So, next time that you see an interest rate listed as a percentage in the nominal form, I hope you remember this article!