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
The periodic rate is the interest rate charged for each period, such as monthly or quarterly. The periodic rate on a credit card with an 18 percent annual percentage rate is 1.5 percent per month. The annual percentage rate is the periodic rate times the number of periods in a year.
What is an example of a periodic interest rate? ›
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%.
How do you define interest rate and how it works? ›
The interest rate is the amount a lender charges a borrower and is a percentage of the principal—the amount loaned. The interest rate on a loan is typically noted on an annual basis and expressed as an annual percentage rate (APR).
What is an example of how interest rates work? ›
For example, if you borrow $100 with a 5% interest rate, you will pay $105 dollars back to the lender you borrowed from. The lender will make $5 in profit. There are several types of interest you may encounter throughout your life. Every loan has its own interest rate that will determine the true amount you owe.
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.
How do you calculate APR from periodic rate? ›
Daily periodic rate example calculation
Let's say one of the credit cards in your wallet carries an APR of 19.99%. You can figure out the daily periodic rate by dividing the APR by 365—or by 360, depending on which number your issuer uses. If you divide 19.99% by 365, you get 0.0548%.
What is an example of periodic in real life? ›
The movement of planets around the sun and the motion of a yo-yo are all examples of periodic functions. Though the example of a pendulum is a special case of periodic function because it executes simple harmonic motion, the difference lies in how the motion is mathematically expressed.
How do you explain interest rates simply? ›
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 how interest is calculated? ›
For example, if you take out a five-year loan for $20,000 and the interest rate on the loan is 5 percent, the simple interest formula would be $20,000 x .05 x 5 = $5,000 in interest.
How do interest rates actually work? ›
Interest rates are calculated in two ways. Simple interest is tallied as a percentage of the principal over time, but compound interest (also called compounding interest) includes accrued interest along with the principal. Most loans and savings deposits use compound interest. Interest on your interest.
An interest rate determines the cost of asking for a loan or saving money. For example: asking for a $1,000 loan for 1 year with a simple interest rate of 10%. With the simple interest formula: A=P*(1+R*t)= 1,000(1+0.1)=1,100; the interest on the loan is 100.
What is an example of interest in simple interest? ›
"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 a real life example of interest? ›
For example, a bank will pay you interest when you deposit your money in a high-yield savings account. The bank pays you to hold and use your money to invest in other transactions. Conversely, if you borrow money to pay for a large expense, the lender will charge you interest on top of the amount you borrowed.
What is 12% APR? ›
But what exactly would a 12% APR mean for you in terms of your interest payments? Here are a few examples: If you were to borrow $1,000 and repay monthly over 6 months, you'd pay $35 in interest total. If you were to borrow $500 and repay monthly over 12 months, you'd pay $33 in interest in total.
What is the difference between nominal and periodic interest rates? ›
Nominal rate: Percent annual rate; Periodic rate: Rate that gives percent interest each period. When compound-interest rates are given as above, the percent annual rate is called the nominal rate and denoted by j.
What is periodic simple interest? ›
To calculate simple interest monthly, we have to divide the yearly interest calculated by 12. So, the formula for calculating monthly simple interest becomes (P × R × T) / (100 × 12).
What is one example of a periodic trend? ›
Major periodic trends include atomic radius, ionization energy, electron affinity, electronegativity, valency and metallic character. These trends exist because of the similar electron configurations of the elements within their respective groups or periods; they reflect the periodic nature of the elements.
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 the periodic interest on a credit card with a 17.99 APR? ›
Say your current balance is $500 for the whole month and your APR is 17.99%. Find your daily periodic rate by dividing your current APR (17.99%) by 365. Your daily APR in this case would be approximately 0.0492%. Then, multiply the $500 by 0.00049—which brings the daily periodic rate is $0.25.
