Whether you’ve ever taken out a personal loan or not, you’ve probably heard of the term interest rate. But did you know that there are usually two types of interest rates when you take out a loan? There’s the advertised rate, and then there’s the effective rate (EIR).
So, what is the difference between the two interest rates, and why are they different?
What Does It Mean When A Rate Is Advertised?
The nominal rate is also known as the advertised rate. This is the rate at which the lender charges you interest on the money you borrow. When it comes to rates that are publicized, there are two categories.
The interest rate on a flat rate loan remains constant during the term of the loan. For loans such as vehicle loans and personal term loans, a flat rate is commonly employed.
Here’s an example of a 2.5 percent monthly flat rate interest applied to an S$80,000 car loan over 5 or 8 years.
|Payments||5-year loan||8-year loan|
|Total amount paid||S$90,000||S$96,000|
You’ll see that the monthly payment for the 8-year loan is smaller, but the total repayment amount is higher.
Monthly Rest Rate
Interest is calculated depending on the outstanding loan balance for the monthly rest rate. This means that as you pay off your loan and the balance drops, the interest amount decreases as well. The term “monthly rate” is more typically used in the context of home loans.
Take, for example, a S$600,000 loan with a fixed rate of 3.5 percent per year and a 20-year repayment period. You also have a monthly loan payment of S$3,480.
When you look at the “Monthly Interest” column in the table below, you can see how the figure decreases as your house loan is paid off over time. Because the 3.5 percent interest rate is applied to a loan balance that falls month after month, this is the case.
|Year||Interest rate||Monthly principal (A)||Monthly interest(B)||Monthly repayment(A+B)||Yearly repayment|
What is the EIR (Effective Interest Rate)?
The actual cost of your loan is reflected in the effective interest rate (EIR). Other expenditures, such as administrative or processing fees, are factored into the EIR. It also takes into account the compounding effect, which is influenced by the length of your loan and the regularity with which you repay it.
Always remember to compare the EIR while comparing different loan packages during your search because it indicates the genuine cost of accepting the loan.
What Makes Effective Interest Rates Higher Than Advertised Rates?
The majority of us are aware that loan interest entails repaying a larger sum than the original loan amount. The advertised interest rate is responsible for the disparity.
On the other hand, banks and licensed moneylenders levy additional fees that, when combined with the interest charged on your loan, raise the total amount you owe the financial institution. Administrative or processing costs, for example, may be charged as part of the loan. Consider the following scenario: a $5,000 loan with a 5% interest rate and a 1% administration fee.
|Administrative fee (1%)||S$50|
The effective interest rate is 6% when the administrative charge is factored in. The administrative charge, on the other hand, is only one factor that influences the EIR. There are also the following aspects to consider:
- The loan’s maturity
- Installment frequency
- If the installment amounts are the same
The payback plan is made up of the three components mentioned above.
But, how does EIR respond to the payback schedule? In a word, the greater your EIR, the more frequently you make payments.
How to Calculate the Effective Interest Rate
So, how do you go about calculating EIR? The formula is as follows:
[ (1 + (nominal interest rate / no. of compounding periods) ^ (no. of compounding periods) ] – 1
For most loans, the “compounding period” is one month. Also, keep in mind that the “nominal interest rate” is not the same as advertised. Instead, it refers to the balance of your loan’s internal rate of return.
It’s also worth noting that the EIR methodology ignores extra expenditures like administrative and processing fees. However, such costs will already be accounted for in financial firms’ EIRs. You may always utilize online EIR calculators to calculate EIRs if you want to calculate them yourself but aren’t sure what formula to apply. What you’ll only have to do is to fill in the blanks with information like the nominal interest rate, loan period, and payment frequency.
Is it always the best deal to take out a loan with the lowest effective interest rate?
In general, the loan with the lowest EIR should be chosen. That way, regardless of the reported rate, you’ll know you’re selecting the loan with the lowest cost.
However, in some cases, the loan with the lowest EIR may not be the best alternative. Even if a loan has a low EIR, you should keep these two other things in mind before opting to take it out.
1. What Is The Total Amount Of Interest On The Loan?
Because you are repaying a smaller sum each month, a longer loan tenure will result in a lower EIR. On the other hand, a longer loan term means you’ll have to pay more interest on the loan.
Because the EIR isn’t the only component determining the total interest you’ll pay, a lower EIR doesn’t always mean you’ll pay a lower total interest amount for your loan.
2. Is the Monthly Repayment Amount Affordable?
Some banks may entice you with a loan with a lower EIR when you take on a shorter term. While this may seem appealing because you’ll be able to pay off your loan and get out of debt faster, you’ll have to make larger monthly payments. Make sure you’re ready financially. You don’t want to be unable to make your monthly payments, or worse, to default on them.
Also, always remember that if you don’t repay your loan on time, you’ll face additional penalties as well as a higher interest rate on the remaining balance. As a result, you can end yourself paying more than you anticipated.