Effective Rate of Interest (EIR)
The effective interest rate, also known as the annual percentage rate (APR), is the true cost of borrowing money. It takes into account not only the interest rate, but also any additional fees or charges associated with the loan. The effective interest rate is typically higher than the nominal interest rate, as it reflects the total cost of borrowing over the entire term of the loan. It is usually expressed as a percentage and is used to compare different loan options and understand the true cost of borrowing.
Effective Interest Rate (EIR) as per Indian Accounting Standards (Ind AS) is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, where appropriate, a shorter period to the net carrying amount of the financial asset or financial liability.
Ind AS 109, Financial Instruments, requires that an entity should recognize the interest income or interest expense on an effective interest rate basis. This means that the interest income or expense for each period should be recognized by using the effective interest rate, which is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, where appropriate, a shorter period to the net carrying amount of the financial asset or financial liability.
This calculation helps in determining the true cost of borrowing or lending and helps in comparison of different financial instruments.
Expected life of a financial instrument
The expected life of a financial instrument is the period over which an entity expects to hold the financial asset or financial liability. It is used to determine the effective interest rate, which is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument.
The expected life of a financial instrument can be affected by various factors, such as the contractual terms of the instrument, the prepayment or call options, the credit quality of the counterparty, and the entity’s own credit policy. For example, for a long-term loan, the expected life of the financial instrument would be the full term of the loan. However, for a loan with a call option, the expected life would be the earlier of the contractual maturity date and the date on which the loan is expected to be called.
Cost of borrowing
The cost of borrowing or lending refers to the expense incurred by a borrower to obtain a loan or by a lender to provide a loan. The cost of borrowing can include interest, fees, and other charges associated with the loan. The cost of lending can include the interest earned on the loan, as well as any fees or charges associated with providing the loan.
For borrowers, the cost of borrowing is typically expressed as the annual percentage rate (APR), which is the true cost of borrowing money, taking into account not only the interest rate, but also any additional fees or charges associated with the loan. For lenders, the cost of lending is typically expressed as the interest rate that is paid on the loan.
It’s important for borrower to compare the cost of borrowing among different loans options, and for lender to compare the rate of return on different investment options to make informed decisions.
EIR as per US GAAP
Effective Interest Rate (EIR) as per US Generally Accepted Accounting Principles (US GAAP) is the rate that discounts the estimated future cash payments or receipts over the life of the financial instrument to the net carrying amount of the financial asset or financial liability.
US GAAP requires that an entity should recognize interest income or interest expense on an effective interest rate basis. This means that the interest income or expense for each period should be recognized by using the effective interest rate, which is the rate that discounts the estimated future cash payments or receipts over the life of the financial instrument to the net carrying amount of the financial asset or financial liability.
The EIR calculation helps entities to determine the true cost of borrowing or lending, and to compare different financial instruments. The expected life of financial instrument is a key input in the calculation of EIR and it’s important to understand the life of the financial instrument in order to evaluate the true cost of borrowing or lending.
What is prepayment
Prepayment refers to the act of paying off a loan or debt before it is due. This can be done in full or in part, and can be voluntary or involuntary. A borrower may choose to prepay a loan in order to save on interest costs or to pay off the loan more quickly. A lender may also require a borrower to prepay a loan if the borrower defaults on the loan or if the lender decides to call the loan.
In the context of financial instruments, prepayment refers to the situation where a borrower can pay off the entire or a portion of the loan or debt before the maturity date, which is the date when the loan or debt is due. This can happen because of a prepayment option or a call option, which is an option that allows the lender to demand repayment of the loan or debt before the maturity date.
Prepayment can have an impact on the cash flow and the true cost of borrowing or lending, and it’s important to take into account when evaluating the financial instruments.
Credit quality of the counterparty
Credit quality of the counterparty refers to the ability and willingness of a borrower to repay a loan or debt. It is an assessment of the creditworthiness of the borrower, and is used to determine the level of risk associated with lending money to that borrower. The higher the credit quality of the borrower, the lower the risk of default, and the lower the cost of borrowing.
The credit quality of the counterparty is determined by credit rating agencies, which assess the financial strength of the borrower and assign a credit rating. The credit rating is an indicator of the borrower’s ability to repay the loan or debt and is used by lenders to assess the risk of lending money to that borrower.
When assessing the credit quality of the counterparty, lenders consider various factors such as the borrower’s financial strength, credit history, and ability to generate cash flow. They also consider the industries in which the borrower operates, economic conditions and the borrower’s management team. A lower credit quality of the counterparty would increase the risk of default and therefore increase the cost of borrowing.
