Periodic Interest Rate

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DEFINITION

The interest rate charged on a loan or realized on an investment over a specific period of time. Most interest rates are quoted on an annual basis. If the interest on the loan or investment compounds more frequent than annually, the annual interest rate must be converted to a periodic interest rate where interest charged or realized over each compounding period can be calculated. This calculation is made by dividing the annual interest rate by the number of compounding periods.

INVESTOPEDIA EXPLAINS

For example, the interest on a mortgage is calculated monthly. If the annual interest rate is 8%, the periodic interest rate used to calculate the interest charge due in any single month would be 0.08 / 12 = .00666 or 0.666%.

Keep in mind that the more frequently an investment compounds, the more quickly the principal grows. For example, let's say two options are available on an investment of $1,000.

Option 1 - Invest $1,000 at 8% compounded monthly.
Option 2 - Invest $1,000 at 8.125% compounded annually.

At the end of 10 years, Option 1 grows to $2,219.64. Option 2 grows to $2,184.04. Even though the interest rate on Option 2 is higher by 0.125%, the more frequent compounding of Option 1 (caused by the earning of interest on interest) yields a higher end amount.


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