### Explain what is the effective interest rate

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Illustrates what is known as discount interest. Imagine you are discussing a loan with a somewhat unscrupulous lender. You want to borrow \$20,000 for one year. The interest rate is 12.5 percent. You and the lender agree that the interest on the loan will be .125 × \$20,000 = \$2,500. So, the lender deducts this interest amount from the loan up front and gives you \$17,500. In this case, we say that the discount is \$2,500.

What is the effective interest rate?

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