If you’ve been searching the web for the perfect way to secure a loan, then you must understand interest rates.
But have you ever heard of the two main interest rates when it comes to bank loans? The simple interest rate and the effective interest rate (EIR).
Wherever you stand, you can be sure of one thing, you landed on the right spot.
The words that follow below offer you an opportunity to learn about what is effective interest rate on loan. In addition, you will find out how it is calculated in Singapore.
Without wasting any more time, let’s dive in.
What Is The Simple Interest Rate?
Let’s begin here because it’s usually the first cost to think about when you want to take out a loan.
A simple interest rate is the amount of money a bank charges on the principal amount of the loan you will take.
In other words, the simple interest rate is a percentage charged on the principal amount of a loan. It is also called the advertised rate, nominal rate, or flat rate.
To calculate the simple interest rate, you will need to use this formula below:
Simple Interest rate =P ×I × Tl where:
P=Principal
I=Interest rate
Tl=Term of loan (or loan enure), in years.
Let’s use the example below for you to better picture the formula.
You want to take a loan of $10,000 from a bank or financial institution. You want to repay the loan over a period of 10 years. The interest rate of the bank or financial institution is 5% on your $10,000 loan for the next 10 years.
This means that your simple interest rate is equal to $10,000 x 0.05 x 10, which is $5,000.
Meaning that you will pay $5,000 to the bank or financial institution over a period of 10 years.
The simple interest rate is just part of the cost of taking a loan from a bank. Other costs exist. The EIR brings out some of them. But then, what is EIR all about?
What Is EIR?
EIR, meaning the effective interest rate, is the interest you pay on a loan, plus other financial charges associated with the loan.
It considers the fact that you are repaying a portion of the principal borrowed each month while still paying an interest rate based on the initial sum borrowed.
It also considers the compounding effect. This is where the length of your loan and frequency of repayment are factored in.
The EIR gives you a more accurate representation of the total cost of borrowing.
By understanding EIR, you can make sure that you are getting the best deal on your loan or credit.
Insisting on what is effective interest rate on loan protects you against financial institutions—banks or licenced money lenders—that could attempt to use low interest rates as a disguise to hide fees or offer you unreasonable repayment terms.
Let’s See How To Calculate Effective Interest Rate
The EIR formula considers two main variables or elements.
The elements are the nominal interest rate and the compounding periods. Let’s see what the EIR formula looks like below.
EIR = [ (1 + (nominal interest rate / no. of compounding periods) ^ (no. of compounding periods) ] – 1
The “nominal interest rate” in the formula doesn’t refer to the advertised rate. The nominal interest rate here is the internal rate of return on your balance.
The EIR formula may not consider additional costs such as admin fees or processing fees. These are already factored when banks calculate their EIRs.
There’s some good news if you’re still struggling to calculate what is effective interest rate on loan.
Right now, as you read this article, financial institutions in Singapore are legally bound to reveal the effective interest rate of their loans.
Following the Code for Advertising Practice for Banks, any interest-bearing loan must have the effective interest rate.
Also note that you can use an online EIR calculator for Singapore, to do your effective interest rate calculation.
So Why Are Effective Interest Rates Typically Higher Than Advertised Rates?
First, there’s this very important point. Banks and licenced money lenders almost always add on other charges, such as processing fees and administrative fees.
To give you an example, let’s say you borrow S$5,000 with a 5% interest rate and a 1% administrative fee. So when you factor in the administrative fee, the effective interest rate jumps to 6%.
Secondly, to better understand what is EIR in a loan, you need to know that the administrative fee is just one piece of the puzzle.
You have other considerations, including the loan’s term, the frequency of payments (installment frequency), and the consistency or stability (or lack thereof) of installment amounts.
The repayment schedule is the union of all these factors.
The more frequent your payments, the higher your EIR – so don’t forget to consider all the factors.
Lastly, the situation when you are an individual taking out a loan is particular.
Every month, you will have to repay a portion of the principal amount to the bank or financial institution. This means you will not use the entire principal amount for the duration of the loan.
In the meantime, the financial institution or bank charging you for that loan has already received part of its principal back. As a result, your effective interest rate will be higher.
At the end of the day, the effective interest rate simply informs all borrowers of the cost of the loan.
This is why you need to know what is effective interest rate on loan before you consider borrowing money from a bank or financial institution.
Speaking of borrowing money, how do you pick the best loan offer?
How To Choose The Best Loan
Now it’s time for you to apply for a loan.
When trying to choose the best loan, the one with the lowest effective interest rate is usually the best pick. Yet, you will need to be careful.
Though the lowest EIR is a great indicator for choosing the best loan, this may not always be the case.
Weigh all the options before making your final decision, even if a loan has an alluringly low EIR.
Let’s see two of those important options below.
1. What Will The Total Interest On Your Loan Be?
The total interest you pay on the loan depends on the loan’s tenure.
A longer loan tenure may seem like a great idea. This is because the total interest is divided over a longer period, thus resulting in a lower EIR.
However, there’s a catch.
In this scenario, this will also lead to increased total interest as the principal will be paid off over a longer period of time.
Therefore, it’s important to remember that a lower EIR does not always mean you’ll pay a lower amount of interest in the end.
2. Can You Deal With The Cost Of The Monthly Repayment?
If you have cashflow issues, it’s wise to stay away from offers to pay off your loan quicker. Why? This is because of higher monthly repayments.
Opting for a shorter tenure might look like an attractive option, as the EIRs are lower.
Yet, if you’re considering a loan with a lower EIR on a shorter tenure, make sure you’re ready to handle the higher monthly payments.
You don’t want to be struggling with your repayments, or worse yet, falling behind. Otherwise, you could find yourself unable to meet your payments or even worse, defaulting on your loan.
So What Next?
You now have all the necessary knowledge to determine what is effective interest rate on loan, and how to calculate it.
In case you are in a financial emergency, reach out to us.
At U Credit, we offer flexible, straightforward loan terms tailored to fit your budget and repayment capability.
You will benefit from simple and quick paper-processing methods. You can apply for a loan now.
