What Is a Periodic Interest Rate?
Let me explain what a periodic interest rate is. It's the rate charged on a loan or earned on an investment over a specific period. You know how lenders usually quote interest rates annually? Well, in most cases, the interest compounds more often than once a year. So, to get the periodic interest rate, you divide the annual interest rate by the number of compounding periods.
Here's something important you should note: A higher number of compounding periods means interest gets earned on or added to previous interest more times.
How a Periodic Interest Rate Works
The number of compounding periods directly impacts the periodic interest rate for an investment or loan. For instance, if an investment has an effective annual return of 12% and compounds monthly, its periodic rate is 1%. If it's compounding daily, the periodic rate drops to about 0.00033, which equates to 0.03% for the period.
You need to understand that the more frequently an investment compounds, the faster it grows. Consider this scenario with a $1,000 investment. In option one, you get an 8% annual rate compounding monthly. In option two, it's 8.125% compounded annually.
After 10 years, option one turns your $1,000 into $2,219.64, while option two gets you $2,184.04. See how the more frequent compounding in option one gives a better return, even with a slightly lower rate?
Key Takeaways
- Lenders typically quote interest rates on an annual basis, but the interest compounds more frequently than annually in most cases.
- Interest on mortgages usually compounds monthly.
- Credit card lenders typically calculate interest based on a daily periodic rate so the interest rate is multiplied by the amount the borrower owes at the end of each day.
Example of a Periodic Interest Rate
Take a mortgage as an example—interest there compounds monthly. If the annual rate is 8%, the periodic rate for each month is 8% divided by 12, which is 0.0067 or 0.67%.
That means each month, you apply this 0.67% to the remaining principal balance of the loan.
Types of Interest Rates
The annual interest rate you hear quoted on loans or investments is the nominal rate—that's before considering compounding. The effective interest rate is what you actually deal with after compounding effects are factored in.
To calculate the effective annual interest rate, you need the nominal rate and the number of compounding periods. Divide the nominal rate by the compounding periods to get the periodic rate. Then, add 1 to that, raise it to the power of the number of periods, and subtract 1.
For a mortgage with a 6% nominal rate compounding monthly, the periodic rate is 0.5%. Add 1 to get 1.005, raise to the 12th power for 1.0617, subtract 1, and you have an effective rate of 6.17%—slightly higher than nominal.
With credit cards, they use a daily periodic rate, multiplying it by your daily balance and adding it up. They quote an APR, but you find the daily rate by dividing APR by 365 (or sometimes 360).
Special Consideration
Some revolving loans give you a grace period where no interest accumulates if you pay off the balance by a certain date in the billing cycle. Check your contract for the exact details on any grace period.
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