The different kinds of interest rates and plans

Hi,

After talking with a student I figured that the quick overview I had on Monday might caused a little confusion regarding effective interest, effective interest rate and simple interest (it even confused me for a couple of minutes). So inorder to avoid further confusion, here is a summary of what you should know, hopefully it will help.

Kinds of Interest Rates

There are 3 kinds of interest rates:

  • j – effective interest rate
  • i – nominal interest rate
  • r – real interest rate

Kinds of Interest Programs

There are 4 kinds of interest programs:

  • Simple interest: FV=PV*(1+jt)
  • Effective interest: FV=PV*(1+j)^t
  • Compounded Interest: FV=PV*(1+i/n)^nt
  • Continuously Compounded Interest: FV=PV*e^rt

We noted that effective interest is the same as compounded interest when it is compounded yearly, however (and here begins the confusing part) it is computed using the effective interest rate. Now, the simple interest plan also uses the effective interest rate (which is the second cause for confusion) but it is compounded once in the whole loan period and not yearly.

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