Banks will quote you the effective rate of interest. The effective rate of interest is also known as the annual percentage rate (APR). The APR or effective rate of interest is different than the stated rate of interest.
If you borrow $1000 from a bank for one year and have to pay $60 in interest for that year, your stated interest rate is 6%
Here is the calculation:
Effective Rate on a Simple Interest Loan = Interest/Principal = $60/$1000 = 6%
Your annual percentage rate or APR is the same as the stated rate in this example because there is no compound interest to consider. This is a simple interest loan.
If you borrow $1000 from a bank for 120 days and the interest rate is 6%, what is the effective interest rate?
The effective rate on a Loan with a Term of Less Than one Year = $60/$1000 X 360/120 = 18%.
The effective rate of interest is 18% since you only have use of the funds for 120 days instead of 360 days.
Effective Interest Rate on Installment Loans
One of the most confusing interest rates that you will hear quoted on a bank loan is that on an installment loan.
Effective rate on installment loan = 2 X Annual # of payments X Interest/(Total no. of payments + 1) X Principal
Effective rate/installment loan = 2 X 12 X $60/13 X $1,000 = 11.08%