Whether you’ve taken a loan before or not, interest rate is a term you’re sure to have heard of. But did you know there are usually 2 types of interest rates when you take out a loan? There’s the advertised rate, and the effective interest rate (EIR).
So why are there 2 interest rates and what exactly is each one all about?
What’s An Advertised Rate?
An advertised rate is also known as the nominal rate. This is essentially the interest rate that the lender charges you on the amount that you borrow.
When it comes to advertised rates, there are 2 different types.
1. Flat Rate
Under a flat rate, the interest stays the same throughout your loan tenure. A flat rate is usually used for loans such as car loans and personal term loans.
Here’s an example of a 2.5% monthly flat rate interest applied to a S$80,000 car loan at a 2.5%, with a loan tenure of 5 years and 8 years.
|Payments||5-year loan||8-year loan|
|Total amount paid||S$90,000||S$96,000|
You may notice that while the monthly payment for the 8-year loan is lower, the overall repayment sum is larger.
2. Monthly Rest Rate
For monthly rest rate, interest is derived based on the outstanding loan balance. What this means is that as you repay your loan and the loan balance decreases, the interest amount also reduces. Monthly rate is more commonly applied to home loans.
As an example, you take up a S$600,000 loan that’s payable over 20 years at a fixed rate of 3.5% per annum. You also make a loan repayment of S$3,480 every month.
Looking at the “Monthly interest” column in the table below, you can see that the figure goes down as you repay your home loan over the years. This is because the 3.5% interest rate is applied to a loan balance that decreases every month.
|Year||Interest rate||Monthly principal (A)||Monthly interest
So What Is Effective Interest Rate (EIR)?
An effective interest rate (EIR) essentially reflects the actual cost of your loan.
EIR takes into account other costs such as administrative fees or processing fees. It also considers the compounding effect, which is where your loan tenure and frequency of repayment come into play.
When you’re comparing between different loan products during your search, always remember to compare the EIR since this reflects the true cost of taking the loan.
Why Are Effective Interest Rates Typically Higher Than Advertised Rates?
Most of us know that loan interest results in you having to pay back a higher amount than the amount you loaned. The difference in this amount comes from the advertised interest rate.
However, banks and licensed moneylenders also charge other fees that when added to the interest applied on your loan, increases the total amount you pay back to the financial institution.
For example, there can be administrative fees or processing fees involved in the loan. Let’s consider the example of a S$5,000 loan with an interest rate of 5% and an administrative fee of 1%.
|Administrative fee (1%)||S$50|
With the administrative fee in the picture, the effective interest rate is 6%.
However, the administrative fee is just one component that affects the EIR. There are also other factors that come into play:
- Tenure of the loan
- Frequency of the instalments
- Whether the instalment amounts are equal
The 3 factors above combined can be referred to as the repayment schedule.
So how exactly does the repayment schedule affect EIR? In a nutshell, the more frequent your instalments are, the higher your EIR will be.
Effective Interest Rate: How To Calculate It
So how exactly can you calculate EIR? Here’s the formula:
[ (1 + (nominal interest rate / no. of compounding periods) ^ (no. of compounding periods) ] – 1
The “compounding period” is 1 month for most loans. Also, note that the “nominal interest rate” doesn’t refer to the advertised interest rate. Instead, it refers to the internal rate of return on your loan’s balance.
You’ll also want to note that the EIR formula doesn’t factor in additional costs such as administrative fees or processing fees. However, such costs will already be factored into the EIRs provided by financial institutions.
If you would like to calculate EIRs yourself but are confused with the formula, you can always use online EIR calculators to calculate them. All you have to do is key in values like the nominal interest rate, loan tenure, and frequency of instalments.
Is A Loan With The Lowest Effective Interest Rate Always The Best Deal?
In general, it’s best to go for the loan with the lowest EIR. That way, you know that you’re picking the loan with the lowest cost regardless of the advertised rate displayed.
Having said that, there are instances where the loan with the lowest EIR may not always be the best option. Even if a loan has a very low EIR, you should remember to consider these 2 other factors before deciding to take up the loan.
1. What Is The Total Interest You’ll End Up Paying For The Loan?
A longer loan tenure will result in a lower EIR since you are repaying a lower amount every month. However, a longer loan tenure also means you have to pay more interest for the loan.
A lower EIR may not always imply that you’ll be paying a lower interest amount in total for your loan, since it’s not the sole factor determining the total interest you’ll pay.
2. Is The Monthly Repayment Amount Within Your Means?
Some banks may tempt you with a loan with a lower EIR when you take up a shorter tenure.
While this may be enticing since you’ll get to pay off your loan quicker and clear your debt sooner, you’ll need to make higher monthly repayments.
Do make sure that you’re financially prepared for this. You don’t want to end up struggling to make your repayment each month, or worse still, default on repayments.
Also note that if you can’t repay your loan on time, you’ll have to fork out additional fees and even a higher interest rate on the loan balance. This could eventually cause you to pay more than what you were prepared to.