Calculating the Effective Annual Interest Rate
I plan to use the next few blogs to talk about the Pros and Cons of various financial products offered to borrowers. Pay Day Loans, PO Financing, Factoring, Asset Based Lending, and various Conventional Bank Products will be examined and compared.
So that we use a common measurement tool we will use the Effective Annual Interest Rate (or the Annual Percentage Rate) to compare the cost of alternatives. This gives you an accurate cost comparison between different options. A related subject is the net contribution any borrowing activity makes to profitability. This key decision making variable will be addressed in a later blog.
The following formula is used:
Cost/Money x 360/Days = Effective Annual Interest Rate
The formula takes the nominal cost of the money, Cost/Money, with the second half, 360/Days, annualizing that nominal figure.
- Cost = Total actual cash charges for the loan including interest, setup and maintenance fee.
- Money = The actual cash in hand from the loan. This is net of upfront fees or reserves deducted from the loan amount.
- 360 = The standard number of days in a year utilized in loan calculations.
- Days = Days the loan is outstanding.
- Cost = $20
- Money = $1,000
- Days = 90
Therefore: 20 X 360 = .08 or 8%
Our next installment will start to look at some costs and some comparisons.