What is the difference between a stated interest rate and an effective
interest rate, and which is recognized by financial managers as the
true cost of borrowing?

Hi gabriel6886!!

The definitions show  clearly the difference between both concepts:

- Nominal or Stated Interest Rate:
 The stated, or contractual, interest rate in a loan agreement, bond
or other security.

- Effective Rate:
 The actual yield of interest as opposed to the stated rate. For
deposits, the effective rate of interest is based on the accounting
method used to compute interest and the frequency of compounding. For
loans, the effective rate is the stated interest rate plus fees and
charges prorated over the estimated life of the mortgage.


See more at "NOMINAL AND EFFECTIVE INTEREST RATES" from ALBERT EDDY
TEACHING SITE, DEPARTMENT OF FINANCE, LOYOLA COLLEGE IN MARYLAND:
http://webdev.loyola.edu/aeddy/net320/nomeffect.htm


"Effective Rate (Effective Yield):
The effective rate is the actual rate that you earn on an investment
or pay on a loan after the effects of compounding frequency are
considered.  To make a fair comparison between two interest rates when
different compounding periods are used, you should first convert both
nominal (or stated) rates to their equivalent effective rates so the
effects of compounding can be clearly seen.
The effective rate of an investment will always be higher than the
nominal or stated interest rate when interest is compounded more than
once per year. As the number of compounding periods increases, the
difference between the nominal and effective rates will also increase.
To  convert a nominal rate to an equivalent effective rate:

Effective Rate = ((1 +  (i / n))^n) - 1  

Where:   
   i = Nominal or stated interest rate
   n = Number of compounding periods per year"
From "Interest" at Financial Software Components - Cedar Spring
Software, Inc site; I suggest you to visit this page:
http://www.getobjects.com/Components/Finance/TVM/iy.html


See also the following page:
"Credit: Figuring the True Cost (APR) of Credit" By Sandy Preston:
'The Federal Truth-in-Lending law requires lenders to tell you the
annual percentage rate (APR) and the total finance charge in dollars
when you apply for credit. However, they may not do so. In some cases,
the exact annual percentage rate may not be known until all specifics
of the transaction have been decided.
When the creditor tells you the interest rate, you can be sure you are
being quoted the true APR and that it is the rate being written into
the credit contract by doing some simple calculations. These
calculations also allow you to compare rates from different creditors
for the best deal.
Convert quoted interest rates to APR by using the following formulas...'
http://ianrpubs.unl.edu/consumered/nf512.html


The following Lecture Notes (PowerPoint presentation) gives you
examples and further clarifications regarding to this topic:
http://econ.ucsb.edu/~sleroy/Econ134aW04/114.ppt

You can download for free the PowerPoint Viewer to see this document
if you haven't installed the MS PowerPoint from the Office suite (File
size: 2,837 KB):
http://download.microsoft.com/download/OfficeXPProf/Install/4.71.30.1/W98NT42KMe/EN-US/PPVIEW97.EXE

PowerPoint Viewer page:
http://www.microsoft.com/office/ork/xp/appndx/appa13.htm


the following paragraphs gives you an idea of the usefulness of the
Effective rate concept:
"The Corporation considers a loan impaired when, based on current
information and events, it is probable that the Corporation will be
unable to collect all amounts due according to the loan's contractual
terms. The allowance against losses for impaired loans represents
management's judgment of the present value of expected future cash
flows discounted at the loan's effective interest rate."
From "Notes to the Financial Statements - Summary of Significant
Accounting and Related Policies":
http://www.iic.int/annualreport/2001_fin_notea.asp?flashInstalled=yes


"A bank should measure an impaired loan at its estimated realisable value:
The valuation of loans should reflect any diminution in the estimated
realisable value below their recorded investment. The carrying amount
of a loan that has been identified as impaired should therefore be
reduced to its estimated realisable value. The determination of this
amount should take into account all relevant information such as the
current economic situation of the borrower, the solvency of the
debtor, the enforceability of personal guarantees and the ability of
guarantors to perform, the current value of collateral, and rating
agency ratings. The estimated realisable value should be calculated by
using the following methods:
·The present value of expected future cash flows discounted at an
appropriate interest rate, i.e., the effective interest rate inherent
in the loan. The estimates of future cash flows should be the bank's
best estimate based on reasonable and supportable assumptions and
projections;
·The fair value of the collateral to the extent the loan is
collateral-dependent. A loan is fully collateral-dependent if
repayment of the loan is expected to be provided solely by the
underlying collateral;
·The observable market price, if it is a reliable indicator of the
loan's estimated realisable amount."
From "Accounting for Loans" at IFCI Foundation - International
Financial Risk Institute website:
http://newrisk.ifci.ch/145220.htm


So by definition and usefulness, the effective interest rate is considered the
true cost of borrowing.


Search strategy:
"stated interest rate" "effective interest rate"
stated effective interest rate


I hope this helps you. Remember to don't consider this answer ended
until your entire satisfaction with it. Before rate this answer, if
you feel that the answer is incomplete and or unclear, please use the
clarification feature until you are completely satisfy with it. I will
be glad to respond your requests.

Best regards.
livioflores-ga

Thank you for the thorough research and subsequent explanation!  I am
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