Concepts

• The mathematics here are straightforward. You take out a loan of $10,000 at an annual fixed rate of 6 percent. The bank writes in your loan papers that this 6 percent will be charged each month. This means that the 12 months are divided into 6, leading to a monthly interest rate charge of .5 percent. In effect, each month the loan is due will cost you .5 percent of the principal. In this example, .5 percent of 10,000 is 50.
  
  

The Mathematics

• The effect of this kind of rate policy, if you are a borrower, is to increase the interest charge on the loan without explicitly stating it. You, as a borrower, must be careful how the yearly rate is calculated during the term of the loan. The outstanding principal of our hypothetical $10,000 loan increases each month by .5 percent. That means the next month, the .5 percent rate will operate on a principal that is now $10,050. The following month, that .5 percent will be assessed on the new principal of $10,050, and that comes to $50.25. The following month, therefore, the principal the .5 percent is assessed upon is then $10,100.50.
  
  

The Problem

• If you are a borrower and the bank offers 6 percent, you should ask how this is assessed. If it is monthly, then the net effective rate is 6.17 percent a year, once compounded .5 percent is assessed in each new month. The fact is that the principal is getting larger, and thus, the interest rate is actually increasing.
  
  

Significance

• Using the net effective concept, banks can manipulate interest rates.The advertised rate, in other words, is actually higher depending on how often this rate is compounded. If you are not careful, the bank will gradually increase the principal you borrowed through compounding the rate over the term of the loan.