Effective Interest Rate is the rate that unravels the actual profit earnings through investment over a time frame. It is used to denote the comparison between the compounded annual interests over the different days, weeks, months etc.
EIR doesn’t convert interest rates into compounded rates annually like the Annual Percentage Rate.
It plays a pivotal role while calculating the future value or present value of an object. This method is largely used to calculate discount rates on bonds and investments as well.
On that note, let us discuss the 4 factors that cause a change in the interest rates –
Borrowers and Lenders
A money lender is taking a risk by lending a person his money. There is always a chance that the borrower may not return that money. The interest is the token of compensation for bearing that risk.
When a bank is lending out money, they charge interest for the same reason. If we see this from the borrower’s point of view, they are getting the money to spend now.
So the interest is the price they are paying for their convenience and saved uptime.
Demand and Supply
The flow of demand and supply is a major factor that changes effective interest rate changes. The rate of interest is directly proportional to the demand for money in the market.
That implies that the rates will rise with the increasing demand for money, and a slump in demand for money sees the fall in interest rates as well. Info about ACS Citation Generator
If we look at real-world transactions, when we are making a deposit in a bank, the bank use that fund to provide loans to some others.
The more a bank lends, the more money gets pushed into the market. As the credit supply keeps on increasing, the interest rate gets down.
When inflation affects the market, lenders demand higher interest rates. The prices of every good rise, and the purchasing power of that same amount of money goes down.
With higher interest rates, the lenders protect their interest from an inflated market.
Government policies often play a deciding role in whether interest rates will go up or down. The monetary policies, fiscal rates, government-aided projects all affect the supply of money to or from the market.
If you are deciding to invest in debt or an equity policy or planning to purchase a house, it is always wise to take note of an effective interest rate.
Understanding the calculation method and the rate-changing factors are crucial to making every financial decision in your life.
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