What Is a Periodic Interest Rate?
A periodic interest rate is a rate that can be charged on a loan, or realized on an investment over a specific period of time. Lenders typically quote interest rates on an annual basis, but the interest compounds more frequently than annually in most cases. The periodic interest rate is the annual interest rate divided by the number of compounding periods.
A greater number of compounding periods allows interest to be earned on or added to interest a greater number of times.
How a Periodic Interest Rate Works
The number of compounding periods directly affects the periodic interest rate of an investment or a loan. An investment's periodic rate is 1% if it has an effective annual return of 12% and it compounds every month. Its periodic interest rate is 0.00033 if you are compounding the daily periodic rate, it would be the equivalent of 0.03%.
The more frequently an investment compounds, the more quickly it grows. Imagine that two options are available on a $1,000 investment. Under option one, the investor receives an 8% annual interest rate and the interest compounds monthly. Under option two, the investor receives an 8.125% interest rate, compounded annually.
By the end of a 10-year period, the $1,000 investment under option one grows to $2,219.64, but under option two, it grows to $2,184.04. The more frequent compounding of option one yields a greater return even though the interest rate is higher in option two.
Key Takeaways
- Lenders typically quote interest rates on an annual basis, but the interest compounds more frequently than annually in most cases.
- Interest on mortgages usually compounds monthly.
- Credit card lenders typically calculate interest based on a daily periodic rate so the interest rate is multiplied by the amount the borrower owes at the end of each day.
Example of a Periodic Interest Rate
The interest on a mortgage is compounded or applied on a monthly basis. If the annual interest rate on that mortgage is 8%, the periodic interest rate used to calculate the interest assessed in any single month is 0.08 divided by 12, working out to 0.0067 or 0.67%.
The remaining principal balance of the mortgage loan would have a 0.67% interest rate applied to it each month.
Types of Interest Rates
The annual interest rate typically quoted on loans or investments is the nominal interest rate—the periodic rate before compounding has been taken into account. The effective interest rate is the actual interest rate after the effects of compounding have been included in the calculation.
You must know a loan's nominal rate and the number of compounding periods to calculate its effective annual interest rate. First, divide the nominal rate by the number of compounding periods. The result is the periodic rate. Now add this number to 1 and take the sum by the power of the number of compounding interest rates. Subtract 1 from the product to get the effective interest rate.
For example, if a mortgage compounds monthly and has a nominal annual interest rate of 6%, its periodic rate is 0.5%. When you convert the percentage to a decimal and add 1, the sum is 1.005. This number to the 12th power is 1.0617. When you subtract 1 from this number, the difference is 0.0617 or 6.17%. The effective rate is slightly higher than the nominal rate.
Credit card lenders typically calculate interest based on a daily periodic rate. The interest rate is multiplied by the amount the borrower owes at the end of each day. This interest is then added to that day's balance, and the whole process happens again 24 hours later—when what the borrower owes is typically more unless they have made a payment because now their balance includes the previous day's interest. These lenders often quote an annual percentage rate (APR), glossing over this daily periodic rate calculation. You can identify your daily periodic rate by dividing the APR by 365, although some lenders determine daily periodic rates by dividing by 360.
Special Consideration
Some revolving loans offer a "grace period" from accumulating interest, allowing borrowers to pay off their balances by a certain date within the billing cycle without further interest compounding on their balances. The date and duration of your grace period, if any, should be clearly identified in your contract with the lender.
FAQs
Example of a Periodic Interest Rate
What is an example of a periodic interest rate? ›
For example, if the annual interest rate on a loan is 10%, and the loan is paid monthly, the periodic rate would be 10% / 12 = 0.833%.
What is an example of how interest rates work? ›
If you take out a $300,000 loan from the bank and the loan agreement stipulates that the interest rate on the loan is 4% simple interest, this means that you will have to pay the bank the original loan amount of $300,000 + (4% x $300,000) = $300,000 + $12,000 = $312,000.
How do you calculate the periodic rate? ›
Here is an example:
If your current balance is $500 for the entire month and your APR rate is 17.99%, you can find your daily periodic rate by dividing your current APR by 365. In this case, your daily APR would be approximately 0.0492%. By multiplying $500 by 0.00049, you'll find your daily periodic rate is $0.25.
What is the definition of a daily periodic interest rate? ›
A daily periodic interest rate generally is used to calculate interest by multiplying the rate by the amount owed at the end of each day. This interest amount is then added to the previous day's balance, which means that interest is compounding on a daily basis.
Why is periodic interest rate important? ›
Knowing what the periodic interest rate and compounding periods are enables borrowers to calculate how much interest will accrue on debt outstandings over a set period of time. Credit card companies take a daily periodic rate to calculate interest owed on credit card balances at the end of each day.
What is an example of periodic finance charge? ›
For example, an APR of 18 percent converts to a monthly periodic rate of 1.5 percent -- the result of 18 divided by 12. If your outstanding balance is $1,000 you will be charged monthly interest of $1,000 multiplied by 1.5 and divided by 100, which equals $15.
What is interest rate with an example? ›
For example, if a savings account is to pay 3% interest on the average balance, the account may award 0.25% (3% / 12 months) each month. The applicable interest rate is then multiplied against the outstanding amount of money related to the interest assessment. For loans, this is the outstanding principal balance.
What is a simple way to explain interest rate? ›
To put it simply, interest is the price you pay to borrow money — whether that's a student loan, a mortgage or a credit card. When you borrow money, you generally must pay back the original amount you borrowed, plus a certain percentage of the loan amount as interest.
What is an example of interest rate in real life? ›
For example, assume you have a car loan for $20,000. Your interest rate is 4%. To find the simple interest, we multiply 20000 × 0.04 × 1 year. So, by using simple interest, $20,000 at 4% for 5 years is ($20,000*0.04) = $800 in interest per year.
Periodic interest rate cap refers to the maximum interest rate adjustment allowed during a particular period of an adjustable rate loan or mortgage. The periodic rate cap protects the borrower by limiting how much an adjustable-rate mortgage (ARM) product may change or adjust during any single interval.
What is periodic compounding interest rate? ›
Periodic compounding
r is the nominal annual interest rate. n is the compounding frequency. t is the overall length of time the interest is applied (expressed using the same time units as r, usually years).
What is an interest period? ›
The interest period or conversion period is the time between successive conversions of interest into principal and is commonly three months, six months, or one year, where such case interest is compounded quarterly, semiannually, or annually, respectively.
How can I calculate my interest rate? ›
The formula for calculating simple interest is: Interest = P * R * T. P = Principal amount (the beginning balance). R = Interest rate (usually per year, expressed as a decimal). T = Number of time periods (generally one-year time periods).
What is an interest rate that changes periodically? ›
A floating interest rate is an interest rate that changes periodically. The rate of interest moves up and down, or "floats," reflecting economic or financial market conditions.
What type of interest rate changes periodically? ›
A floating interest rate is an interest rate that changes periodically. The rate of interest moves up and down, or "floats," reflecting economic or financial market conditions.
What is an example of a simple interest rate? ›
"Simple" interest refers to the straightforward crediting of cash flows associated with some investment or deposit. For instance, 1% annual simple interest would credit $1 for every $100 invested, year after year.
What is an example of a compound interest rate? ›
To illustrate how compounding works, suppose $10,000 is held in an account that pays 5% interest annually. After the first year or compounding period, the total in the account has risen to $10,500, a simple reflection of $500 in interest being added to the $10,000 principal.
