Understanding Effective Cost: Beyond Interest Rates

Effective cost is the total cost of borrowing, not just interest charges.

When you borrow money, you must repay the principal amount plus interest. Interest is charged based on a simple or nominal rate. Typically, lenders also add fees to the principal. These may be loan processing fees, "points" added to a mortgage or a variety of other charges. Added together, interest and fees make up your finance charges. Effective cost or annual percentage rate uses total finance charges to find the true cost of a loan expressed as a percentage rate.

Formula to Estimate Effective Cost

Precise determination of effective cost requires complex mathematics. You can calculate an estimate of effective cost using a fairly simple formula. First, find the total finance charges by adding all of the interest charged over the life of the loan to other fees. The formula to approximate effective cost is 2(F * N)/(A * (T + 1)). F equals total finance charges, N is the number of payments per year, A equals the total repayment amount and T is the total number of payments. Suppose you borrow $1,000 and the finance charges total $250, so the amount you must repay equals $1,250. You make monthly payments over a two-year period. You have 2($250 * 12) divided by ($1,250) * (24 + 1). This works out to an approximate effective cost or APR of 19.2 percent.