Effective Interest Calculation 

Use

The effective interest calculation determines the effective interest rate, which represents the actual costs of the capital or the actual revenue from a capital investment.  The bank must specify the total annual charge for loans as a percentage price, for example.

If the interest rate agreed with the customer is valid for the whole term of the loan, then this is known as the effective annual interest rate. If the interest rate agreed with the customer is valid for part of the term only, then this is known as the initial effective annual interest rate.

It can be difficult for bank customers to compare the products from different providers even if the general conditions are the same (same term, same disbursement amount) because the details of the conditions can differ, for example:.

●      Agreement with different interest rates for different periods

●      Conditions for interest calculation during the year

●      Discount or premium, which means that disbursement or inpayment amount varies from the nominal value for which interest is to be calculated.

●      No immediate repayment settlement; monthly repayments do not reduce interest calculation capital until end of year, for example.

●      Account maintenance charges, commitment interest, processing costs, and so on.

For this reason, it is desirable to be able to use a comparable interest rate to assess and compare products, which is based on standardized conditions. This comparable interest rate is the effective interest rate. This enables customers to compare and assess the financial products of different providers whose effective interest rate was determined using the same effective interest method.

Integration

The following graphic shows the relationship between the Effective Interest Calculation function and other FIMA functions:

Features

At the center of the effective interest rate calculation is the effective payment history, which results from the cash flow of a financial transaction.

The cash flow begins with a capital amount, such as the disbursement amount for a loan, or the purchase amount for a security. This is followed by other related flows, such as those resulting from the conditions. The effective interest rate calculation includes nominal interest, processing charges, premium/discount, and the effect of the repayment clearing method as the cost factor.

Either linear or exponential interest is applied to the cash flow amounts. You use the interest formulas for linear interest calculation or for exponential interest calculation.

The system uses a comparison account for calculation of the effective interest rate, which contains all actual payments from the bank and customers. These include the disbursement, installments, and the remaining debt at the end of the fixed interest period. For the purposes of the effective interest calculation, it does not matter whether these flows are interest payments or repayments. The comparison account only recognizes incoming and outgoing payments. Investments are interpreted as incoming payments to the comparison account, repayments are disbursements from this account.

For more information about the clearing account, see Clearing Account as Model for Effective Interest Rate Calculation.

The system uses an iterative mathematic procedure to calculate the internal interest rate under which the balance of the comparison account is zero after the last payment, or the balance of the comparison account is the same as the remaining balance of the financial transactions (except for rounding differences). This interest rate is the effective interest rate.

The following graphic shows the basic structure of the effective interest rate calculation:

In FiMa, the effective interest rate calculation is executed in the function module EFFEKTIVZINS_BERECHNEN. The system uses the following function modules to set up and calculate cash flows in the clearing account. For more information, see the system documentation for the individual function modules.

●        DEFINE COMPARISON ACCOUNT

●      SCALE COMPARISON ACCOUNT

Example

You can find a detailed example of effective interest calculation under effective interest rate methods, which works out the difference between individual effective interest rate methods.