Example:
A company has an interest rate of 24% per annum with interest added every month. This corresponds to 2% interest per month. (See the explanation above if necessary.)
What is the debtor interest rate?
In this problem we must consider two concepts:
The annual nominal interest rate and the annual effective interest rate.
If there are several periods/interest additions within a year, the interest rate per period is found by dividing the stated rate, the annual nominal interest rate, by the number of periods. In the example above, the annual nominal interest rate is 24%, which must be divided over 12 months. This gives 2% per month.
The total interest added over a year is called the annual effective interest rate.
The effective rate differs from the annual nominal interest rate because the amount on which the 2% is calculated becomes larger each month as interest is added. In other words, compound interest is applied to the interest additions already after the first compounding. Therefore, the interest that is actually added during a year (the effective interest rate) will be higher than the nominal interest rate.
Debtor interest rate = (1 + r%)n − 1
r = The interest rate per period
n = Number of interest additions per year.