If you have ever taken out a loan or are thinking of taking one, you must have probably come across the terms effective interest rate and simple interest rate. Both the effective interest rate and simple interest rate are often advertised by banks and private money lenders. If you’re confused by these two different interest rates, we understand you. Banks don’t often explain what each term means and it can be daunting to jump into a loan contract without understanding every detail.
Understanding the difference between the two before taking a loan is crucial as it can affect how much money you will have to pay in the long run. Which interest rate is more important?
This article will discuss simple and effective interest rates, their formula together with how to calculate interest rates, and how these interest rates affect your loan. Let us help you make a fully informed decision.
What Is Simple Interest Rate/Flat Interest Rate?
A simple interest rate is the interest rate the bank charges you on the loan you have taken from them. It is also known as the nominal interest rate or the flat rate.
This interest rate is usually given in percentage and is calculated on the amount of money you borrowed. The calculation is quite direct and straightforward. It can also be used on investments as well. The simple interest rate is generally lower than the effective interest rate.
Simple Interest Rate Formula
The simple interest rate is calculated using the formula: SI=P x R xT, where:
- SI is the amount of interest
- P is the principal or the initial investment
- R is the interest rate
- T is the time period
This is the amount of borrowed money and the starting point for calculating the interest. For example, if you need to take a $10,000 personal loan, your principal amount is $10,000.
Interest Rate (%)
This is the interest charged on a loan, calculated based on the interest rate and the principal. It is expressed as a percentage.
It is the length of time that the loan is for. This can be expressed in years, months, days, or any other unit of time. It can also be know as the loan tenure.
How to Calculate Simple Interest?
To simplify the calculation of simple interest, take the following scenario as an example:
- Loan amount: $10,000
- Tenure: 10 years
- Processing fee: $100
- Simple interest rate: 10% per annum
If you take a loan like this, you first get $9,900 in hand as a $100 processing fee is taken at the time of disbursement. You then have to pay an interest of $1,000 per year for the next ten years to completely repay the principal amount.
Most of us understand interest rates, which unfortunately do not consider several things. One of them would be the processing fee. It is often overlooked. The processing fee is a standard fee for both banks and financial institutions. However, the amount varies and there might be promotions once in a while.
What Is the Effective Interest Rate?
The effective interest rate is the rate of interest paid on a bank loan after considering any fees or charges that may be payable. It is the actual cost of borrowing money.
Unlike the simple interest rate, the effective interest rate takes into account that you are repaying part of the principal every month and still have to pay an interest rate based on the initial sum of money you borrowed.
Why Is the Effective Interest Rate Crucial?
The effective interest rate is crucial to lenders and borrowers for several reasons:
- The effective interest rate is used to calculate the actual cost of borrowing. This includes the interest rate charged by the lender and any fees or points paid by the borrower.
- The effective interest rate is used to compare different loans. By understanding the actual cost of each loan, borrowers can make informed decisions about which loan is right for them.
- The effective interest rate is used to calculate the amount of interest that accrues on loan. This is important for both borrowers and lenders, as it helps ensure that the loan is repaid on time and that the lender receives the total interest owed.
Effective Interest Rate Formula
The effective interest rate formula is given by:
EIR=(1+r/n)^n – 1 where:
- r is the stated rate on the loan
- n is the number of compounding periods per year.
As we can see from the formula, the effective interest rate is higher than the quoted rate. This is because we are paying the processing fee, and we are also considering that we are repaying the principal amount each year.
Now that we know how to calculate the effective interest rate let us go back to the example and calculate the EIR.
EIR=(1+10%/1)^1 – 1=10.38%. From the example, we can see that the EIR is 10.38%. This means that even though the simple interest rate is 10%, we are effectively paying 10.38% when we factor in the processing fee and the repayment of the principal amount.
How Will Interest Rates Affect My Loan?
This is the most important question as the loan repayment will affect your finances for the next few years. It is crucial to identify your loan’s interest rate before taking it. This is because the interest rate will affect your loan in various ways.
Interest rate affects the amount of money you will have to pay in interest for your loan. The higher the interest rate, the more you will have to pay in interest, while the lower the interest rate, the less you will have to pay in interest.
The monthly payment you make for your loan will also be affected by the interest rate. The higher the interest rate, the higher your monthly payment will be. The lower the interest rate, the lower your monthly payment will be. How much are you setting aside for your loan repayment each month?
Interest rate affects the total amount of money you will have to pay for your loan. The higher the interest rate, the higher the total amount of money you will have to pay for your loan. The lower the interest rate, the lower the total amount of money you will have to pay for your loan.
Interest rate affects the time it will take you to repay your loan. The higher the interest rate, the longer it will take you to pay off your loan. The lower the interest rate, the shorter it will take you to repay your loan.
Getting A Personal Loan after Serious Consideration
Having understood both simple and effective loan interest rates, you can know which is best for you.
Take ample time to research and look for the best personal loan. Entering a loan contract is a serious and long-term financial commitment. It is very important to evaluate and consider both simple interest rates and effective interest rates. Ensure that you are able to handle all of the upcoming payments before applying for a loan.
You can get a bird’s eye view of your loan interest rates with a personal loan calculator.
Regardless of the loan amount, you should aim to find an affordable and flexible low interest personal loan. Your future self will thank you for making the right financial decision.