How is EIR calculated?

Understanding the effective interest rate is crucial for borrowers and lenders alike. It helps borrowers compare different loan offers and choose the most cost-effective option. For lenders, it provides a clear picture of the returns they can expect from their lending activities.

The effective interest rate, also known as the EIR, represents the true cost of borrowing money over a specific period. It takes into account the impact of compounding, which is the process where interest earned on a loan is added to the principal balance, and subsequent interest is then calculated on the new, larger balance.

The calculation of the effective interest rate involves using a formula that incorporates the nominal interest rate and the frequency of compounding. The formula is expressed as: Effective Interest Rate = (1 + Nominal Rate ÷ Compounding Periods)^(Compounding Periods) – 1. This formula ensures that the resulting rate accurately reflects the total cost of borrowing over time.

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