The effective rate is also often quoted as 'so many percent compound’ as in 10.9% per annum compound. If you pay the interest on the loan monthly then the rate that applies is the nominal rate. In this case the effective or actual rate of annual interest applies if the interest on the debt is rolled up into the amount borrowed and hence owed. The same sort of reasoning applies to loans. This is the effective, or actual, annual rate of interest that applies to an investment - as long as the interest isn’t withdrawn each month. If you make an investment with the interest reinvested then it is clear that the effect of compounding will result in you being paid more interest at the end of the year than the simple nominal annual rate would suggest.įor example, if you invest $100 at a nominal rate of 10% per annum compounded monthly, at the end of one year you will have earned $110.47, not the $110 that the nominal interest might lead you to believe.īecause of compounding the effective interest rate per annum appears to be 10.47% and this is what a Bank or other institution might consider is the annual interest worth quoting because it allows for the compounding that will almost certainly occur. This brings us to the idea of nett and gross rates.įinally we consider some issues of working with different compounding periods. This leads us to the idea of the 'effective' annual interest rate and then on the formalised Effective Interest Rate or Annual Percentage Rate, the much quoted EIR/APR.Īs well as changes to effective rates due to compounding, there is also the question of how the effect of tax and tax allowances can be summarised within an interest rate. In particular, we like to summarise the effect that compounding has on the underlying or nominal interest rate. This is such a common form of financial transaction that we tend to treat it as something special. In the previous chapter we discovered that compound interest is nothing more than the repeated application of simple interest to the accumulated total of the principal and the interest to date. Understanding exactly what it means is a good step toward making correct use of it. The IRR is perhaps the most complicated of the measures of the value of an investment with an irregular cash flow. How is it possible to evaluate investments that generate irregular cashflows? We explore how NPV can be used to make investment decisions.Īdvanced Investment Analysis IRR and MIRR The calculations are just a matter of breaking down the cash flow calculations into simple steps. The principles of present and future value apply even if the cash flow is irregular. Repayment loans are the subject of the last of three chapters which look at the effects of regular cashflows. We move on to annuities in the second of three chapters devoted to exploring the way in which interest rate affects In the first of three chapters covering the way in which interest rate affects cashflow we explore savings - but first we introduce some general ideas that apply equally to annuities and repayment loans.
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