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The purpose of the explanatory examples on this page is to assist you in selecting between two methods of calculating effective interest rates.
Suppose we have to set up two floating interest rates.
The first set is named Effective interest rate as a percentage.
Margin type = Percentage of the base rate that is subtracted from the base rate.
Default margin rate = 40%.
The second set is named Effective interest rate as a difference.
Margin type = Fixed percentage that is subtracted from the base rate.
Default margin rate = 2%.
The picture below shows how effective interest rates change with different base rates:
Base rate of 5%
Moderate increase to 7%
Moderate decline to 3%
Substantial decline to 1%
Given the base rate will rise to 7%, then the applied effective rates will be 4.2 and 5 and calculate:
7 - (0.4 * 7) = 7 - 2.8 = 4.2.
7 - 2 = 5.
Conclusion 1: When the base rate increases, the effective interest rate, calculated as a difference from the base rate, grows more than the interest rate, calculated as a percentage of the base rate.
Given the base rate will decline to 3%, then the applied effective rate will be:
3 - (0.4 * 3) = 3 - 1.2 = 1.8.
3 - 2 = 1.
Conclusion 2: When the base rate decreases, the effective interest rate, calculated as a difference from the base rate, declines more than the interest rate calculated as a percentage of the base rate.
Given the base rate will decline to 1%, then the calculated effective rate will be:
1 - (0.4 * 1) = 1 - 0.4 = 0.6.
1 - 2 = -1. -> 0.
Conclusion 3: When the base rate decreases lower than the default margin rate, the calculated effective interest rate as a difference from the base rate has a negative value. The applied rate is 0, as the value of the effective interest rate can not be negative.
To choose between two margin type configurations for floating interest, consider these differences:
The effective interest rate, calculated as the difference between the base rate and the margin rate, is more sensitive to changes of the base rate than the interest rate calculated as a percentage of the base rate.
The effective interest rate calculated as the difference between the base rate and the margin rate, becomes 0 when the base rate drops below the default margin rate.
The effective interest rate, calculated as a percentage of the base rate, is positive as long as the base rate is positive.