Effective interest rate

Effective interest rate – The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses.

The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate (see IFRS 9 paragraphs B 5.4.1–B 5.4.3), transaction costs, and all other premiums or discounts. There is a presumption that the cash flows and the expected life of a group of similar financial instruments can be estimated reliably.

However, in those rare cases when it is not possible to reliably estimate the cash flows or the expected life of a financial instrument (or group of financial instruments), the entity shall use the contractual cash flows over the full contractual term of the financial instrument (or group of financial instruments).


Calculation example:

The loan is CU 50,000, monthly payment CU 1,250, loan period 5 years. The add-on interest rate ([total monthly payments / loan amount) – 1] / loan period x 100%) is 10%.

What is the effective interest rate?

The spreadsheet way: Discount 60 monthly terms (5 years 12 months) of CU 1,250 against a chosen interest rate until the discounted value is equal or very close to CU 50,000. The answer is 17.2737% per annum. Make a table Period 1 – 60 1,250 and discount all until the discounted sum nears 50,000. Or use the IRR function on this table.

Description

Returns the internal rate of return for a series of cash flows represented by the numbers in values. These cash flows do not have to be even, as they would be for an annuity. However, the cash flows must occur at regular intervals, such as monthly or annually. The internal rate of return is the interest rate received for an investment consisting of payments (negative values) and income (positive values) that occur at regular periods. Effective interest rate Effective interest rate Effective interest rate

Syntax

IRR(values, [guess])

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The IRR function syntax has the following arguments:

  • Values    Required. An array or a reference to cells that contain numbers for which you want to calculate the internal rate of return.
    • Values must contain at least one positive value and one negative value to calculate the internal rate of return.
    • IRR uses the order of values to interpret the order of cash flows. Be sure to enter your payment and income values in the sequence you want.
    • If an array or reference argument contains text, logical values, or empty cells, those values are ignored.
  • Guess    Optional. A number that you guess is close to the result of IRR.
    • Microsoft Excel uses an iterative technique for calculating IRR. Starting with guess, IRR cycles through the calculation until the result is accurate within 0.00001 percent. If IRR can’t find a result that works after 20 tries, the #NUM! error value is returned.
    • In most cases you do not need to provide guess for the IRR calculation. If guess is omitted, it is assumed to be 0.1 (10 percent).
    • If IRR gives the #NUM! error value, or if the result is not close to what you expected, try again with a different value for guess.

Remarks

IRR is closely related to NPV, the net present value function. The rate of return calculated by IRR is the interest rate corresponding to a 0 (zero) net present value. The following formula demonstrates how NPV and IRR are related:

NPV(IRR(A2:A7),A2:A7) equals 1.79E-09 [Within the accuracy of the IRR calculation, the value is effectively 0 (zero).]

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Or the website way: Use for example this calculator: The Flat to Effective Interest Rate Calculator 


Effective interest rate

Effective interest rate    Effective interest rate

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

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