Eli5: Can anyone explain “simple interest rate” vs “effective interest rate”?

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Can anyone explain “simple interest rate” vs “effective interest rate”?
For loans with fixed term e.g. car loans.

In: Economics

3 Answers

Anonymous 0 Comments

Simple interest is just the interest rate x principal without compounding. Effective includes compounding.

So if you had a two year investment for $100 at 5%, the second year interest payment would calculated on $105 (100+5 from the interest in year 1) so you would get $5.25 interest in year 2.

Therefore 5% Simple Interest but your Effective was slightly higher.

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