Definition: What is the borrowing rate and what is the effective annual rate?
If you take out a loan, you will be charged interest on the borrowed money. That is the price you have to pay for the loan. In most cases, the interest is paid monthly. A distinction is made between two types of interest.
- The borrowing rate, also called nominal interest rate: It indicates how much interest you only have to pay for the loan amount.
- The effective interest rate, also known as the annual percentage rate: It is intended to show the total price and, in addition to the debit interest rate, also includes the loan costs that the bank charges you. Therefore, in most cases the effective interest rate is higher than the borrowing rate. The term, the purpose and the creditworthiness of the borrower are also used to calculate the effective interest. According to the EU consumer credit directive, the effective interest rate has to be stated for all offers for installment loans since 2010.
As a donkey bridge for differentiating between the types of interest, you can note that the borrowing rate corresponds to the basic rent for an apartment. The effective interest rate, on the other hand, corresponds to the warm rent, which includes the additional costs.
The effective interest rate as a recommended comparison value – but watch out!
The effective interest rate should therefore be the “price tag” for the real estate loan. For this reason, it has mostly been recommended in the past years to carry out a credit comparison based on the effective interest rate, since this should already include all the costs incurred. As a borrower, you could get a good overview of the future load and compare the offers. However, this recommendation is not fully valid.
The problem: banks calculate the effective interest rate differently
At the beginning of 2019, the Bremen Consumer Advice Center found that the composition of the effective interest rate for real estate loans could not be tracked in around 20% of the loan offers examined. In addition, identical cost items in different offers were designated with different terms, which made it even more difficult for experts to compare mortgages. There can be no question of transparent pricing of construction loans.
It was particularly difficult for consumers to compare combinations of financing and building society contract. It is legally required here to specify a common effective interest rate for advance loans and building loan contracts. However, according to the results of the Bremen Consumer Center, some providers did not stick to it.
Good to know: If it is not a matter of real estate financing, but a classic installment loan, the effective interest rate is very suitable as a basis for comparison. The effective interest rate provides reliable information about the costs involved until the loan is repaid in full.
Why is the effective interest rate not always comparable?
Effective interest on mortgage lending cannot always be compared for two reasons. On the one hand, different cost factors and, on the other hand, estimates for the time after the fixed interest rate are included in the calculation.
Reason 1: Different cost factors influence the effective interest rate
Different credit providers use different factors to calculate the effective interest rate. This means that the calculation bases differ. The so-called price regulation stipulates that all costs that have to be paid in connection with the consumer loan contract must be included in the effective interest. However, some credit providers interpret the regulation in such a way that some costs are not directly part of the loan and therefore do not have to be included in the effective interest rate. Controversial claims include:
- Expenditures for appraisers for property valuation
- Notary fees and land registry costs
- Surcharges for possible partial payments
- possible insurance
If these costs are not included, the effective interest is of course lower than with a provider who includes one or the other of these cost points in the calculation. For the chairwoman of the Federal Association of Financial Planners eV, Elgin Gorissen-van Hoek, it is therefore clear: “The effective interest rate only serves as a comparison criterion if it was calculated exactly the same with all parameters.” And that is not always the case.
Reason 2: Estimates flow into the effective interest rate
A building loan, which is also referred to as a home loan or building loan, usually amounts to several hundred thousand USD and the loan is usually only repaid after 30 or 40 years. An agreed fixed interest rate applies for the first few years, after which follow-up financing is necessary. Since the interest is only fixed for the phase of fixed interest, but the effective interest is to apply for the entire term of the loan, the probable interest is estimated after the end of fixed interest. Different approaches are used for this estimation.
An example can illustrate this: You have taken out a loan for the purchase of a house with the following key data:
- Property value: $ 300,000
- Loan amount: $ 200,000
- Fixed interest rate: 15 years
- Total term: 30 years
For the period after the fixed interest rate, banks estimate the then likely interest rate for the preparation of an offer. This estimate is included in the effective interest rate offered, even if it has no direct impact on the current loan. If a loan provider assumes rather low interest rates in 15 years, his current effective interest rate is of course lower than with an estimate with a higher interest level for the second 15-year period.
In some cases, the interest that is valid during the fixed interest period is simply taken and extrapolated over the entire 30-year term of the loan. With savings banks, for example, it is common to use the current interest rate for variable loans as a value for follow-up financing.
You can well imagine that depending on the type of estimate, a different effective interest rate will result for the same loan amount. It is difficult to keep track of things. We describe below how you can do it anyway.
How can mortgage lending be compared to borrowing rate and effective rate?
Even if the effective interest rate is not comparable in all cases, under certain conditions it gives a good starting point for the search for mortgage lending.
Take borrowing rate and effective rate on a single loan
Enter the desired framework conditions in a mortgage comparison. These are the amount of the loan, the repayment rate (percentage of repayment) and the duration of the fixed interest period. From the offers that appear, take a closer look at the respective representative example. These are the conditions that two thirds of all customers receive.
The representative example also shows the borrowing rate for buying a house. If you now choose the offers with the best borrowing rate (formerly called nominal interest rate) for the construction loan, you have already found the cheapest loans in terms of pure interest without further fees and costs.
Let the selected banks and mortgage lenders send you specific offers including a repayment plan. If you have this, you can now compare the effective interest offered. But make sure that the general conditions match in all offers. Independent financial advisor Elgin Gorissen-van Hoek points out: “If you as a customer only need a loan, you can obtain offers with an identical monthly charge and the same fixed interest rate. You should accept the offer with the lowest debit and effective interest rates and, above all, the lowest remaining debt. “
The repayment plan always lists the actual loan costs that were incurred at the end of the term. The lowest value corresponds to the cheapest offer.
Professional advice helps with multiple loans
In many cases, real estate financing consists of several loans. Then take out one or two loans from banks and another as promotional loan from Intrasavings bank. This mix can lead to interest advantages if the loan has different terms.
Conclusion: You should know that about borrowing rate and effective interest rate
Knowing a few facts will help you find real estate finance. This includes, …
- … that the effective interest rate indicates the total credit costs including ancillary costs and the debit interest rate only the costs for taking out the loan.
- … that the effective interest rate is not always suitable for comparing different offers for home loans.
- … that this is due to different calculation bases and the use of estimated values.
- … that when comparing the loan, the borrowing rate, the effective interest rate and, above all, the remaining debt after the fixed interest rate are good starting points when looking for the right mortgage.
However, looking for the right mortgage is not just about the cheapest interest rate. Each house financing is designed individually. Learn more about the optimal strategy on how to finance your home.