FORMULABANK

Example:

A company has an interest rate of 24% per annum with monthly compounding. This results in an interest rate of 2% per month (see the explanation above).

What is the debtor interest?

In this example, we will consider two concepts:

• The annual nominal interest rate
• The annual effective interest rate

If there are multiple compounding periods per year, the interest per period is found by dividing the stated interest rate (the annual nominal interest rate) by the number of periods. In the example above, the annual nominal interest rate is 24%, which is divided across 12 months, resulting in 2% per month.

The total interest accrued over a year is called the annual effective interest rate.

The effective interest rate differs from the nominal interest rate, as the amount from which the 2% is calculated increases each month with the addition of interest. In other words, interest is compounded on the accrued interest right after the first compounding. Therefore, the interest that is effectively accrued over the year (the effective interest rate) will be higher than the nominal interest rate.

The formula for calculating the debtor interest is:

Debitor interrest = (1+r%)ⁿ-1
r = Interest per period
n = Number of compounding periods per year

Calculation:

Nominal interest rate of 24% per annum with monthly compounding