Before you take out a bank loan, you need to know how your interest rate is calculated.

There are
many methods banks use to calculate interest rates and each method will change the amount of
interest you pay. If you know how to calculate interest rates, you will better understand your loan
contract with your bank. You are also in a better position to negotiate your interest rate with your
bank. 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.
Effective Interest Rate on a one Year Loan

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.

Effective Interest Rate on a Loan With a Term of Less Than one Year

If you borrow $1000 from a bank for 120 days and the interest rate is 6%, what is the effective
interest rate?

Effective rate = Interest/Principal X Days in the Year (360)/Days Loan is Outstanding

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 a Discounted Loan

Some banks offer discounted loans. Discounted loans are loans that have the interest payment
subtracted from the principal before the loan is disbursed.

Effective rate on a discounted loan = Interest/Principal - Interest X Days in the Year (360)/Days
Loan is Outstanding

Effective rate on a discounted loan=$60/$1,000 - $60 X 360/360 = 6.38%

As you can see, the effective rate of interest is higher on a discounted loan than on a simple
interest loan.

Effective Interest Rate with Compensating Balances

Some banks require that the small business firm applying for a business bank loan hold a balance,
called a compensating balance, with their bank before they will approve a loan. This requirement
makes the effective rate of interest higher.

Effective rate with compensating balances (c) = Interest/(1-c)

Effective rate compensating balance= 6%/(1 - 0.2) = 7.5% (if c is a 20% compensating
balance)

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. Installment loan interest rates are generally the highest interest rates you will
encounter. Using the example from above:

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%

The interest rate on this installment loan is 11.08% as compared to 7.5% on the loan with
compensating balances.