The nominal interest rate is a crucial economic term frequently discussed in the context of loans. Representing the interest rate on a loan before the inclusion of fees is typically expressed as an annual rate.
To grasp the true cost of a loan it is important to understand the difference between nominal interest rate and effective interest rate. An effective interest rate includes a normal interest rate along with additional fees and costs.
Defining nominal and effective interest rates
The nominal interest rate serves as the base interest rate by financial institutions. This rate includes the interest on the loan, excluding expenses like establishment fees and term fees. The nominal interest rate is providing a base for comparison across different lenders.
The effective interest rate gives a more accurate reflection of what the loan will cost. It includes the overall cost of the loan including nominal interest and any associated fees and costs. It will therefor give a more complete picture of the actual cost of the loan.
Considerations when taking out a loan
When looking to applying for a loan, individuals and businesses often find themselves comparing nominal interest rates offered by various banks. However, relying solely on nominal interest rates can be misleading, as these rates exclude crucial additional costs.
Your business should therefor use the effective interest rate when looking for a loan.
Navigating the loan landscape
Choosing a lender based solely on the lowest nominal interest rate can be an expensive affair. A seemingly attractive nominal interest rate may be accompanied by establishment fees and other hidden charges. Borrowers should review the terms and conditions of the loan closely to find the best alternative.