What is periodic rate?
The periodic rate is the interest rate charged over a certain number of time periods. The periodic rate equals the annual interest rate divided by the number of periods. For example, the interest on a home loan is usually calculated monthly, so if the annual interest rate is 4 percent, then you divide that by 12 and get 0.33 percent. That’s your interest every month.
When a bank charges periodic interest based on the average balance of a loan on a monthly or daily basis, the effective interest rate is actually higher than the stated annual interest rate. The reason is the effect of compounding interest.
With credit cards and overdrafts, the interest is normally calculated on a daily basis; this means the daily interest rate is the annual rate divided by 365 days. Because interest is calculated daily, a large daily balance on the account means you will pay more interest.
The effect of the periodic rate is exacerbated when interest rates are high. For example, if the variable interest rate on a credit card is 16 percent, the daily interest rate would be 0.044 percent.
The effect of the periodic rate can also be used to your advantage when you invest money, as long as you reinvest the interest or profits. In this way, you compound the interest, and over several years the total value of the investment will be greater than if you had taken the interest or profits out each month.
Periodic rate example
Businesses sometimes have difficulty managing cash flow because they pay for raw materials but don’t recover that cost until the goods are sold. To ensure they meet their financial commitments, many use a loan or overdraft facility.
Interest on their loan is charged on a daily basis, so if they draw down a large amount to pay for a big order and repay it a few days later, they may end up paying more interest than they anticipate, even if their average loan balance is low.