Real Interest Rate which you are charged or paid can be categorized into annual percentage rate (APR) and annual effective rate (AER).
Einstein said it best – ‘if you can’t explain it simply, you don’t understand it well enough’.
Financial firms love selling complex products. That way customers don’t know what they’re buying, won’t understand the potential downside risks, or realise the true costs, many of which will be expertly hidden in the small print.
Bank profits are big because as Andrew Ellson, Personal Finance Editor of The Times, perfectly sums up:
Let’s get to this 2 terms which reflect the real interest rate, before I illustrate examples in my subsequent posts.
A qualified financial planner would already be reasonably familiar with the concepts below.
Annual Percentage Rate (APR)
- Also known as nominal rate or simple interest rate per annum
- Does not take into account the effect of intra-year compounding
- Quoted by financial institution when they lend out money, hence earning interest from customers.
- Primary reason being to give customers the impression it costs less to borrow
- Normally applicable to loans, mortgages and credit cards
- Real interest rate charged to you is always effectively lower than the quoted AER
- APR to AER conversion mathematical equation: AER = (1+APR/n)^n – 1
Annual Effective Rate (AER)
- Also know as Effective Annual Rate (EAR), Annual Percentage Yield (APY) per annum
- Takes into account the effect of intra-year compounding
- Quoted by financial institution when customers deposits money, hence paying interest to customers.
- Primary reason being to give customers the impression customer deposits earns more interests
- Normally applicable to savings accounts, fixed deposits.
- Real interest rate paid to you is always higher than quoted APR if there is 2 or more intra-year compounding. The only time when AER=APR is when there is no intra-year compounding,
- AER to APR conversion mathematical equation : APR = n*[(AER+1)^(1/n) – 1], where n = number of times for intra-year compounding.