If you have ever taken out a loan before, you should be familiar with the term “interest rate” which is the cost of the loan.
However, you may be confused about the two types of interest that are always displayed with loan packages – the effective interest rate and the advertised interest rate.
As you read further, you’ll learn what the effective interest rate on loan is, and how it’s different from the advertised interest rate.
Let’s get started.
What Is The Simple Interest Rate?
The simple interest rate, also known as the advertised rate or nominal rate is the usual interest rate a bank or financial institution will charge you on the amount you borrow.
There are 2 ways the advertised interest rate is charged.
- Flat rate
- Monthly rest rate
The interest stays the same throughout the loan tenure for a flat rate. The flat is most times used for loans such as personal loans and car loans.
Whereas for the monthly rest rate, the interest rate reduces as the loan amount decreases because the interest is charged on the outstanding balance of the loan. The monthly interest rate is typically applied to home or property loans.
What Is EIR?
Now you know what the simple interest rate is, what is the effective interest rate on a loan?
The EIR in a loan is the true cost of the loan. It includes other costs in addition to the simple interest rate such as admin charges and processing fees. It also puts into consideration the loan tenure and the frequency of the installment repayment.
This is why for the same loan with different frequencies of repayment, the one with the highest frequency of repayment will have a higher interest rate. However, at the end of the period, the amount of interest paid for the loan will be the same.
Why Are Effective Interest Rates Typically Higher Than Advertised Rates?
The effective interest rate is usually higher than the advertised or simple interest rate because of other fees such as admin or processing fees that are added to the interest.
When you’re borrowing a loan from a bank or licensed moneylender, they can charge you upfront fees for processing the loan or add those fees to your interest and have you pay it back over the period of your loan.
Take for instance you want to borrow a loan of $100,000 and the advertised interest rate is 5%, and processing and admin fees are 2%.
In this scenario, the EIR will be 7% (5+2). At the end of the period, instead of paying a total interest of $5,000 (using the advertised interest rate), you’ll be paying $7,000 (using the EIR).
The additional $2,000 is the 2% admin fee that you would have deducted upfront from the loan amount.
However, as we said earlier, other factors such as loan tenure, and repayment schedules also contribute to making the EIR higher than the advertised rate.
How To Calculate Effective Interest Rate
The effective interest rate calculation is not for the feeble of heart if you don’t like maths. That’s on a light note, but all I’m saying is that it can get a little bit complicated if you’re calculating it manually.
To calculate the EIR on your loan, you have to use this EIR formula:
1 + (nominal interest rate/number of compounding periods)) ^ (number of compounding periods) – 1
Let’s break down this formula for better understanding.
The compounding period is usually a month for most loans. The nominal period is the internal rate of return on the balance of your loan. You’d think it’s the same as the advertised rate, but it isn’t.
Also, keep in mind that the EIR formula doesn’t include admin charges or other charges that separate the EIR from the advertised interest rate.
You see why we said it is a little complicated.
But there is an easier way to calculate the EIR — EIR calculators.
Online effective interest rate calculator Singapore takes the stress out of calculating your EIR for a specific loan.
There is one from the Ministry of Law, which is an excel based EIR calculator that gives you the EIR when you put in the required values such as:
- Nominal interest rate
- Frequency of installment
- Number of installment
- Loan amount.
There is also one from Calculator Soup, which is also effective. It requires you to input the nominal rate, the compounding period, and the number of periods.
While online EIR calculators in Singapore might make calculation easy, they also do not include admin fees or charges.
So How Can I Identify The EIR For A Specific Loan?
Banks and FIs are mandated to publish the EIR for a loan; this is why you usually see the EIR and advertised interest rate.
In some cases, however, you might only see the advertised interest rate. The reason for this could be that the EIR is the same as the advertised interest. However, be triple sure by asking the bank about the EIR before you sign anything.
Is A Lower EIR Always The Best?
While the EIR is a clear indication of the total cost of the loan, sometimes going for the best EIR may not always be the best option.
In addition to an EIR, you also want to consider other factors in place such as:
- The total interest you’ll have to pay: for instance, if you opt for a loan with a longer loan term, you’ll be paying a lower EIR. But, this translates to paying more interest on the loan in the long run.
- The monthly installment amount: the monthly installment usually includes a proportion of the loan and the interest rate. In some cases, you might be presented with a loan with a lower EIR and short loan tenure. However, on the flip side, you’ll be paying a higher monthly installment. You have to make sure you’re financially capable to repay the loan.
In general, try to compare different loans with different EIRs before you take out a loan. Also, use the additional tips below to choose the best loan when borrowing.
How To Choose The Best Loan
In addition to the above, to choose the best loan, keep the following in mind.
1. What Do You Need It For?
The best loan is one that suits you need. If you need to consolidate your debts, a debt consolidation loan is best. If you need to buy a car, a car loan is best. If you need funds for emergencies, a personal loan is best. Always ensure the type of loan you chose matches your need.
2. Repayment Tenure
Go with a repayment tenure that makes it easy for you to repay the loan comfortably. Ensure that the monthly installment repayment is within your means.
3. Terms And Conditions
Find out what the terms and conditions for the loan are. Terms and conditions such as late payment fees, early repayment or cancellation fees, and others. Ensure you are fully aware of what those are before signing anything.
4. Ongoing Promotions
Choose loans that have promotions, perks, and incentives that make sense. This could be in the form of lower interest rates, lower processing fees, cash back, or gift items.
Are You Ready Now To Apply For A Loan?
Now you know what is the effective interest rate on a loan, and how to calculate or find it, if you’re ready to take out a loan personal loan, Lending Bee offers loans with low-interest rates, and quick approval times (less than an hour).
All you need to do is contact us right away to speak with one of our loan experts. They will guide you in choosing the best loan for your needs. You can also apply for a loan online, and get your loan disbursed quickly.
About Ashley Sim
Calling herself a “professional multi-tasker”, Ashley worked as a relationship manager in a bank for five years. She left her job just before the pandemic happened and became a freelance writer for about a year. Now, she’s making the most of her love for writing and knowledge of the banking and financial industry in her role as a content marketing lead. She hopes to help people make better financial decisions through her content and campaigns.