How much does your loan really cost? Check the difference between effective and nominal interest rates

The real cost of a loan can be difficult to find out. Nominal interest rates are often the ones you get presented in communication with the bank, but not the interest you actually pay. Therefore, it is important that you check the effective interest rate when comparing conditions.

The nominal, or par, interest rate is the base rate on a loan or credit. That is, the percentage interest you pay on an outstanding amount in the bank. This is often a figure that may look low at first glance. However, here you should take the time to look carefully to find out what costs are included in the amount you actually pay for your loan – ie the effective interest rate.


Effective interest rate and nominal interest rate: What is the difference?

money loan

The nominal interest rate is the interest rate on the loan, nothing else. Other costs such as establishment fees, frame commissions, termination fees, administration costs, limit commission and any other costs from the bank are not included. Effective interest is a summary of all costs associated with the loan, ie the total price you pay for the loan converted into an actual effective interest cost.

Most banks and finance companies usually market the nominal rates, and it is not always easy to calculate and control what constitutes the effective interest rate for various loans. For example, applying for operating finance means that you are often given a nominal interest rate, but in addition a number of other components that are well hidden in the dealership are imposed. Equally, these components form part of the total cost. And it is this total cost that gives you the effective interest rate.


Be aware of fees and fees

loan fees

Many loans have high costs, which makes the effective interest rate much higher than the nominal.

Take traditional factoring, where the bank takes care of invoice management, that is, all follow-up of invoices, as an example. Such a financing solution has an interest rate on the loan itself. In addition, banks have a number of different fees that come in addition and where the terms differ from bank to bank, so the services can be difficult to compare. To find the effective interest rate, these are examples of costs you can look for in the deal:

  • Interest on the credit limit. This is the interest you pay for actually deducted loan amount at all times
  • Establishment fee for entering into the agreement itself
  • Annual limit commission / frame commission – an annual interest rate for having the credit limit available and calculated based on the size of the frame
  • Administration cost in the form of a price per invoice sent out
  • Turnover commission – a percentage commission that is paid based on the size of each invoice
  • Fee fees when following up unpaid invoices. These often fall to the bank in whole or in part

The difference between the nominal and effective interest rates can, as a result of the above fee structure, differ significantly. It is also important to be aware that although many companies only need to borrow money for a given period of time, for example as a result of seasonal variations, it will still incur significant costs only by having the agreement itself. Thus, low utilization of a credit facility can significantly increase the effective interest rate.

Since banks and finance companies have different solutions for how they charge themselves, it can be difficult to find out the total cost picture. The list of different fees and fees can be long and varied. Some include fees in the loan, and some require you to pay up on loan.


Be aware of the effective interest rate

effective interest rate

It is easy to be tempted by a low nominal interest rate, without examining what costs are included in the total. And it is important to be aware that nominal interest rates are sometimes referred to as merely “interest rates” in the marketing context, which helps to obscure the current cost of the loan.

In practice, this means that it will be more difficult to compare conditions in one supplier’s offer against another supplier. This places greater demands on you as a customer, and it pays to be extra careful to check what different agreements actually entail. Often it requires a well trained eye to find all the factors that influence the final sum.

In all cases, it pays to choose a bank that clearly communicates the effective interest rate and is open about what the loan actually costs. Then you avoid ending up with a loan that is far more expensive than it needs to be.

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