|Introduction: There are three main ways interest rates are commonly described:|
- Simple Interest Rate. This is where the interest rate described by dividing the actual interest paid by the product of the Principal and the fraction of a year represented by the time period. In other words, R = I /PT, or I = P x T x R where I is the total interest paid, R is interest rate per annum, P is the principal and T is time expressed as a fraction of a year. If interest is paid more than once per year, the effective interest rate is somewhat higher than the quoted interest rate.
- AER or "Annual Equivalent Rate". Also known as the "effective" or "annual effective" rate. This is where the interest rate is described as the simple interest rate that would be appropriate if interest had been paid annually in arrears. By quoting this rate the periodicity of the payments does not need to be quoted just to compare the economics of different AER"s, and comparison is the main reason for the use of AER"s. The AER is usually higher than Simple Interest because Simple Interest is usually paid at smaller intervals than yearly.
- Continuous Rate. Another way of providing a level basis for comparing interest rates is to assume that payments are made continuously, perhaps best envisaged as having interest paid every day. Using continuous rates has the same advantage as AER"s in that there is no need to quote the periodicity of payments to make a comparison, the rate is continuous.
A fourth way of dealing with time value of money calculations is to simply calculate the difference in time value between two dates, known as a discount factor. This turns out to be a very good way of working because it avoids the question of "was that simple, AER or continuous".