Implicit interest rate
|Implicit interest rate|
|Methods and techniques|
Implicit interest rate – is a nominal interest rate that is not precisely explicated in a transaction or agreement. The interest rate, however, is implied, as the borrower pays back more than s/he initially borrowed. Even though the rate is not specified, in a contract itself, however, the borrower knows the “sum due”.
Implicit interest rate is applied in loans between friends, family and other less formal situations. However, formal bank agreements use implicit interest rate to evaluate current value of the transaction payment with one in the stated timepoint in the future. In this case the rate can be calculated through two formulas:
- present value of an annuity due (amount of money to be paid at the beginning of a defined period).
- present value of an ordinary annuity (amount of money to be paid at the end of a certain period). It is the difference between the current value and the overall amount paid that is considered as interest in an agreement. The desired implicit rate is also compared to the market interest rate. It is advised that the implicit rate do not differ substantially from the market one. Otherwise, the market rate is eventually considered to be more appropriate while applied to the transaction.
Implicit vs explicit interest rate
As it can be deduced from the naming, explicit interest rate is, on the contrary, clearly stated in any loan agreement or contract. The contract also is to clarify whether the rate is fixed or variable.
Types of agreements where applied
Types of agreements where applied are presented below:
- Lease agreements – the laws of the United States do not obligatory require lenders to opt for explicit rate. Therefore, the accountants include the cost of borrowing in the interest rate. The US laws also state that if the overall payments on the lease are more that 90 per cent of the actual price of the item, the borrower can claim his partial ownership for it. With explicit interest rate the borrower does not have any ownership rights.
- Bond – a financing instrument of dept security that is also based at implied interest rate (though a lot of bonds opt for an explicit one). Implied interest rate in bond demonstrates the difference between the present percentage rate paid on a bond and the percentage rate that the bondholder is going to receive in the defined by contract time in future.
Ways to calculate implicit interest rate
Ways to calculate implicit interest rate are presented below:
- For informal borrowings between friends, for example, the implicit rate can be calculated manually following the formula: x-1 x100 = implicit interest rate raised to power of 1/n, where n=number of payment periods, with subtracting 1 and multiplying the final result by 100. E.g. if we borrow 100,000 and agree to return 125,000 in 5 years. By following the calculation, we get 4.5% of implied interest rate per year.
- For more complex calculations Excel formulas can be more precise. By putting Total Amount Borrowed, Monthly Payment and number of years in column A, and corresponding numbers in column B (e.g. 500,000 £, 5000, 20 years). Then in cell A1 in formula bar the following formula should be tapped =RATE(20*12,-5000,500000). By hitting Return, the program calculates the implied rate.
- For lease agreements the calculations are simpler. E.g. if a company leases a car with total cost 1000£ with 100£ paid each month for 1 year, then by subtracting 1000£ (amount borrowed) from 1200£ (amount due) one can get 20% of interest rate.
- For bond agreements a bondholder needs to follow fluctuations on the market to predict the amount to be added to the dividend per share as it depends on the market rate. E.g. if the amount of dividend per share is 50£ to be paid in one year and due to market changes the dividend becomes 100£ per share – the implicit rate is 50%.
In general, those are small businesses with poor or insufficient financial abilities that are signing lease agreements to get the equipment they need. When leasing something, these small enterprises often deal with implicit interest rates. Implicit interest rate is also mentioned in a contract as a rent or lease payment. To lease a vehicle, the owner may mention a monetary factor that influences his decision on defining the expected interest rate. When multiplying the money ratio by the number needed, the business owner can accurately estimate the adequate annual interest rate.
- Alexander J. (2019), p. 451
- Alexander J. (2019), p. 445
- Brigo D., Mercurio F. (2007), p. 99
- Alexander J. (2019), p. 251
- Homer S. and Sylla R. (2005), p. 416
- Alexander J. (2019) Financial Planning & Analysis and Performance Management, Wiley Finance Series
- Brigo D., Mercurio F. (2007) Interest Rate Models - Theory and Practice: With Smile, Inflation and Credit, Springer Finance
- Homer S. and Sylla R. (2005) A History of Interest Rates, John Wiley & Sons, Inc.
Author: Kamil Piszczek