What is the Effective Interest Rate on a Loan – Explained with Examples

Prepared in partnership with Earlyone. (Google Play, iOs)

When choosing a loan, you might see one bank offering 10% annual interest, while another offers 12% but with no fees. Which one is more favorable? To understand this, simply looking at the loan interest rate isn't enough. The key is to find out the effective interest rate. It's this rate that shows how much you will genuinely pay the bank for using the loan, considering all additional costs.

What is the effective rate?

The effective rate is not just the interest specified in the agreement. It's the total annual cost of the loan, including all payments and fees:

1. loan interest,
2. arrangement fees,
3. service fees,
4. insurance,
5. transfer, appraisal fees, etc.

It is calculated as an annual percentage and shows the true cost of the loan to the borrower. The Central Bank of Armenia monitors the mandatory publication of the effective interest rate by banks to ensure transparent conditions and allow for comparison between loans.

Why is the effective rate more important than the nominal rate?

Nominal rate is only the interest, without considering additional costs.

Effective rate is the real overpayment, including all hidden costs.

Example: A loan at 9% annual interest, but with a 2% origination fee and a monthly service charge – the effective rate can reach 12–13%. Another loan at 10.5%, but with no fees – the effective rate will remain around 10.5%.

Conclusion: A low nominal interest rate does not guarantee a good deal. It's important to calculate everything.

Effective Rate for Different Loan Types

1. Mortgage

Example:

Loan amount: AMD 20,000,000

Term: 15 years

Nominal rate: 10%

Arrangement fee: 1%

Mandatory insurance: AMD 50,000 annually

Effective rate: approximately 11.1–11.4%

Impact: For large sums, even a 1% difference can mean hundreds of thousands of drams in extra costs over the loan's lifetime.

1. Consumer Loan

Example:

Amount: AMD 2,000,000

Тerm: 2 years

Nominal rate: 15%

Arrangement fee: AMD 20,000

Monthly service fee: AMD 1,500

Effective rate: can reach 18–20%

What to consider: Seemingly small fees can dramatically increase the overall cost of a short-term loan.

1. Car Loan

Example:

Amount: AMD 6,000,000

Term: 5 years

Nominal rate: 12%

CASCO insurance: AMD 250,000 annually

Bank fee: 1%

Effective rate: approximately 14–15%

What's important: Mandatory insurance, while often not included in the bank's advertised rates, is still an additional expense for you.

1. Credit Card

Example:

Limit: AMD 1,000,000

Annual rate: 24%

Card service fee: AMD 12,000 annually

No grace period for cash withdrawals

The effective rate can exceed 30–35%, especially if you take cash advances or miss payments.

Important: Mismanaging a credit card can lead to higher total costs than a standard consumer loan.

How to Find the Effective Rate?

In Armenia, banks are required to disclose the effective rate on:

1. official websites,
2. loan agreements,
3. advertising brochures (in fine print),
4. the AFM platform lists only effective rates.

However! Sometimes the effective rate doesn't include expenses for insurance or collateral appraisal if these services are arranged through third-party companies. Therefore:

Always clarify:

1. if all mandatory services are included in the calculation;
2. what amount will be debited on the day of signing;
3. if there are any monthly or annual fees.

What Influences the Effective Rate?

Tips to Avoid Overpaying

1. Don't just believe the numbers on banners.
2. Ask about the effective rate – this is what shows the real cost of the loan.
3. Compare loans with the same term and amount. Conditions vary depending on parameters.
4. Read the contract and ask tough questions. Especially about hidden fees, insurance, and mandatory services.
5. Use a credit calculator. It will show you where it's more beneficial to get a loan and help you avoid unnecessary expenses.

Conclusion

The effective rate is your primary guide when choosing a loan. It helps you understand how much you'll genuinely pay the bank, considering all payments. Whether it's a mortgage, consumer loan, car loan, or credit card, it's crucial to calculate the total cost for each. Before applying, always ask for the effective rate and don't be swayed by marketing slogans like "from 9% per annum."

Compare bank offers on AFM, choose a favorable option, and avoid overpaying.