The effective rate, also known as the effective annual rate (EAR) or effective interest rate (EIR), on a business loan is the true cost of borrowing money, including the effect of how frequently interest is compounded.
The EIR is different from the nominal, simple, or stated rate, which is the number on the loan agreement for the annual interest rate before accounting for compounding.
The effective rate of a loan increases when interest compounds more frequently as shown in this table:
| Stated Rate | Daily | Weekly | Monthly | Quarterly | Annually |
| 10% | 10.52% | 10.51% | 10.47% | 10.38% | 10.00% |
| 15% | 16.18% | 16.16% | 16.08% | 15.87% | 15.00% |
| 20% | 22.13% | 22.09% | 21.94% | 21.55% | 20.00% |
| 25% | 28.39% | 28.33% | 28.07% | 27.44% | 25.00% |
The higher the effective rate, the more borrowers pay in interest, so it’s important to convert stated rates into effective rates when comparing business loan offers from different lenders.
By knowing the true cost of the business loan, the business owner will know if taking the loan is a better decision than self-financing or using a different option like a merchant cash advance. Here’s how to calculate the effective interest rate for your own small business loan.
How to Calculate Effective Interest Rates on Loans
The formula to calculate the effective interest rate (EIR) on a loan is:
- EIR = ( 1 + I / N ) ^ N − 1
“I” is the stated/nominal interest rate and “N” is the number of compounding periods. For a 15% stated rate compounding monthly the EIR will be:
- ( 1 + 15% / 12 ) ^ 12 -1 = 16.08%.
Because the effective rate only tells you the true rate of interest you’ll pay each year, it’s important to take one more step and calculate the total amount of interest you’ll pay each year, because some loans will roll fees into the principal balance.
Effective Rate Impact on Total Interest Paid
You’ll pay more in total interest when you roll fees into the loan balance because the effective rate applies to the total principal amount. Here are two loan options with the same stated rate but different compounding, and $5K is rolled into the amount borrowed for loan 2:
| Loan 1 | Loan 2 | |
| I | 15.00% | 15.00% |
| N | 365 | 12 |
| EIR | 16.18% | 16.08% |
| Amount Borrowed | $100,000 | $105,000 |
| Total Interest Paid | $16,179.84 | $16,879.22 |
| Difference | $699.38 |
Even though loan 2 has a lower effective rate because of the monthly versus daily compounding, rolling $5K in fees into the loan principal means you’ll pay an extra $699.38 in interest.
Using the Effective Rate to Negotiate Loans
By calculating the effective rate across different loan offers, it’s possible to negotiate a better deal for yourself.
Imagine you’re comparing loan offers from two different small business lenders that both offer the same amount, stated rate, and monthly compounding. By offering to pay daily compounding interest in exchange for a quarter point off the stated rate, you’ll save $264.28 in interest.
| Daily | Monthly | |
| I | 20.00% | 20.25% |
| N | 365 | 12 |
| EIR | 22.13% | 22.24% |
| Amount Borrowed | $250,000 | $250,000 |
| Interest Paid | $55,333.96 | $55,598.24 |
| Difference | -$264.28 |
Watch out for other terms when using this tactic, because the effective rate will apply to anything that increases the loan principal, like the example in the previous section where the fees got rolled into the loan balance. Late and missed payment fees are other things to watch out for since they can cause higher interest payments, too.
Paying Down Debt Based on Effective Rate
Using the effective rate helps you decide which loans to pay down first when you have extra cash and want to make curtailments. If you have two loans with the same nominal rate and balance due but different compounding periods, make the curtailment on the loan with the more frequent compounding. That loan will likely have a higher effective rate, helping you save more money.
Effective rates on business loans tell you the true annual rate of interest you’ll pay, based on how often the interest compounds. This gives you a more accurate representation of the financing so that you can compare offers from different lenders to choose what works best for you.
SmallBusinessLoans does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
