What is a periodic interest rate?
A periodic interest rate is a rate that can be applied to a loan or realized on an investment over a specific period of time. Lenders generally offer interest rates on an annual basis, but interest compounded more frequently than annually in most cases. The periodic interest rate is the annual interest rate divided by the number of compounding periods.
A greater number of periods of composition makes it possible to earn or add interest to a greater number of times.
How a periodic interest rate works
The number of compounding periods directly affects the periodic interest rate on an investment or loan. The periodic rate of an investment is 1% if it has an effective annual return of 12% and is compounded every month. Its periodic interest rate is 0.00033, or if you dial the daily periodic rate, it would be the equivalent of 0.03%.
The more frequently an investment is made, the faster it grows. Imagine that two options are available on an investment of $ 1,000. Under the first option, the investor receives an annual interest rate of 8% and interest compounded monthly. Under option two, the investor receives an interest rate of 8.125%, compounded annually.
At the end of a 10-year period, the investment of $ 1,000 under option 1 increases to $ 2,219.64, but under option 2 it increases to $ 2,184.04. The more frequent combination of option one gives a better return even if the interest rate is higher in option two.
Key points to remember
- Lenders generally offer interest rates on an annual basis, but interest compounded more frequently than annually in most cases.
- Interest on mortgages is generally compounded monthly.
- Credit card lenders usually calculate interest based on a daily daily rate, so the interest rate is multiplied by the amount the borrower owes at the end of each day.
Example of periodic interest rate
Interest on a mortgage is compounded or applied on a monthly basis. If the annual interest rate on this mortgage is 8%, the periodic interest rate used to calculate the interest assessed during a single month is 0.08 divided by 12, or 0.0067 or 0, 67%.
The remaining principal balance of the mortgage loan would have an interest rate of 0.67% which would be applied to it each month.
Types of interest rates
The annual interest rate generally quoted on loans or investments is the nominal interest rate – the periodic rate before the composition has been taken into account. The effective interest rate is the actual interest rate after the effects of the composition have been included in the calculation.
You must know the nominal rate of a loan and the number of calculation periods to calculate its effective annual interest rate. First, divide the nominal rate by the number of compounding periods. The result is the periodic rate. Now add this number to 1 and take the sum by the power of the number of compound interest rates. Subtract 1 from the product to get the effective interest rate.
For example, if a mortgage is compounded monthly and has a nominal annual interest rate of 6%, its periodic rate is 0.5%. When you convert the percentage to decimal and add 1, the sum is 1.005. This number at the 12th power is 1.0617. When you subtract 1 from this number, the difference is 0.0617 or 6.17%. The effective rate is slightly higher than the nominal rate.
Credit card lenders usually calculate interest based on a daily daily rate. The interest rate is multiplied by the amount that the borrower owes at the end of each day. This interest is then added to the day’s balance, and the whole process happens again 24 hours later, when the borrower generally owes more, unless he has made a payment, because his balance now includes interest. from yesterday. These lenders often quote an annual percentage rate (APR), bypassing this daily periodic rate calculation. You can identify your daily recurring rate by dividing the APR by 365, although some lenders determine the daily recurring rate by dividing by 360.
Some revolving loans offer a “grace period” from the accumulation of interest, allowing borrowers to repay their balances before a certain date in the billing cycle with no further compound interest on their balances. The date and duration of your grace period, if any, must be clearly identified in your contract with the lender.