What Is Effective Interest Rate On Loan And How Is It Calculated?

 

Did you know learning about effective interest rates can help you choose the best loan?

Imagine browsing for a personal loan and coming across an eye-catching low rate called a simple interest rate and a much higher rate referred to as the effective interest rate (EIR) attached to a single loan product.

This might be confusing, leading you to ask something along these lines, ‘what is effective interest rate on loan or what does EIR mean and why is it more expensive?’

Of the many terms banks use to describe the interest rate of loans, EIR is the most useful one, as it gives a relatively clear picture of the loan cost.

To fully understand what EIR means and how to calculate it, you’ll need to find out more about your loan’s stated terms and perform some simple calculations.

What Is The Simple Interest Rate?

The simple interest rate is the amount your bank charges you for taking out a loan. It’s often lower than the effective interest rate.

Depending on your background, you can call this the advertised, nominal, or flat rate.

To simplify what simple interest means, let’s use an illustration.

Let’s say you apply for a loan worth $100,000. The loan tenure is one year, you should repay in one instalment, and the bank charges you 10% of the loan as the interest rate.

Here’s how to arrive at the simple interest rate: $100,000 ×10/100=$10,000.

So, you will have to pay $10,000 in addition to the principal amount.

While many people understand bank interest rates in this manner, it often doesn’t work this way.

To know the cost of your loan, you should pay attention to EIR. If you still ask, ‘what is effective interest rate?’ find out more about it in the next section.

What Is EIR?

When you take a loan, you pay the simple interest and other charges, such as the processing fee. The effective interest rate takes into account all these charges.

What is EIR, then? EIR is the interest rate that gives you a relatively accurate understanding of the cost of your loan.

Given the same example above, this means you’ll pay the simple interest and processing fee,

Suppose the processing fee is 1% of the loan amount per year. Since you secured $100,000, this equals $1,000 per annum. So, the interest rate increases from $10,000 to $11,000 annually.

Including the processing fees also means the interest rate increases from 10% of the principal amount to 11%.

And processing fee is one of many factors you should consider in effective interest rate calculation.

From our answers to your query, ‘what is effective interest rate on loan?’ you might have noticed that different banks include various factors in the calculations to arrive at their rate.

Other elements that EIR often take into account are:

  • Frequency of instalments
  • Number of instalments
  • The size of instalments

Since lenders are commercial entities, they often determine the monetary value of these factors and can find ways of including them in your effective interest rate.

How To Calculate Effective Interest Rate

Thankfully, you can use the EIR formula to calculate the effective interest rate.

Note that the formula might appear complicated if you have not taken the time to familiarize yourself with it.

Here’s the EIR formula: r = (1 + i/n)^n – 1

Find out what the letters in this formula represent here:

  • R: R means the effective interest rate
  • I: I stands for the nominal interest rate
  • N: N means the number of compounding periods per year

Let’s break down this formula further for easier understanding.

The compounding period for most loans is one month. Also, the nominal rate typically means the internal rate of return on your loan balance.

It’s important to remember that this EIR formula does not include processing fees, administrative fees and other additional costs. So, after getting your answer, you should add these costs manually.

Some people, especially those who aren’t fans of mathematics, think using the formula and adding the figures later is a little complicated.

There’s no problem if you are one of them since the EIR your bank will provide has already included them in the calculations.

The code for advertising practice for banks in Singapore requires financial institutions to include the EIR for any interest-bearing loan.

At this point, we already answered, ‘what is effective interest rate on loan?’ You also know how to calculate it and alternative ways to access this critical information.

However, remember you can use an online effective interest rate calculator in Singapore and get the correct answer instantly. This method is suitable if you want to find an alternative way to calculate the rate on your own.

How do you use an online EIR calculator in Singapore? Key in the required values, such as the number of compounding periods per year, often one month, the loan tenure, and the nominal interest rate.

Why Are Effective Interest Rates Typically Higher Than Advertised Rates?

Effective interest rates are usually higher than advertised rates for a good reason. Some people think banks are being deceitful by advertising cheaper rates. While the two rates can mislead you, it’s not inaccurate to advertise the way banks do.

Banks advertise nominal rates to help you see the exact amount of interest charged on the amount you borrow.

However, as already mentioned, the effective rate increases due to the payment of additional charges. These rates vary depending on factors such as your financial situation, loan amount, loan tenure, and other special needs. So, creating a single loan tailored to each borrower in Singapore is not practical.

So you can answer the vital question, ‘what is effective interest rate on loan?’ Since we’ve discussed it in detail, you can hopefully do this and perform the necessary calculations manually or using an online calculator.

If that’s right, let’s proceed to how you can choose a loan that best suits you.

How To Choose The Best Loan

Most borrowers choose loans with the lowest effective interest rate. This practice makes sense since these loans are sometimes cheaper. It can increase your chances of securing the best loan, no matter the figure the bank displays.

Nevertheless, bear in mind that there are instances when loans with higher effective interest rates can be more affordable.

So, if you want to choose the best loan, consider these two essential factors:

1. The Total Interest You Will End Up Paying

One way to know the total interest you’ll end up paying is to evaluate the loan tenure. In most cases, a longer loan tenure results in a lower effective interest rate because it enables you to repay a lower amount every month.

However, if you look at the big picture, your longer loan tenure means paying more interest.

Think about it this way. You borrow $10,000 from bank AA today, and your friend does the same on the same day. The advertised interest rate is the same. However, you opt for a shorter loan tenure of 30 months, while your friend goes for 90 months.

Considering the need to profit, the bank charges your friend more for using their money for longer. Nevertheless, your EIR is 9.72%, but your friend’s EIR is lower at 9.55% because the loan cost is spread across an extended period. So, you end up paying less.

In this case, the shorter loan tenure is better than its alternative, which provides a longer loan tenure is not always the best.

2. Whether You Can Afford The Monthly Instalments

Your ability to repay the loan per the indicated schedule also determines which loan is the best for you.

For example, in the above case, we’ve said the loan with a shorter tenure is cheaper. However, remember you have to make higher monthly instalments to save on the costs. Assuming you can’t make the instalments in time. In this case, it’s a wrong choice.

You’ll have to incur additional fees if you can’t meet your debt obligation. Therefore, in most instances, a loan you can afford is the best.

Use An Online Calculator To Determine Effective Interest Rate On Your Loan

An online calculator can save you a lot of time calculating the effective interest rate. It’s also often error-free.

The code for advertising practice for banks is another life-saver. It requires banks to display EIR to protect borrowers like you. So, you can consider using the stated rate when looking for the best loan.

Did you miss out on anything about how to choose the best effective interest rate in this article?

Our experts at Katong Credit are well-trained and will help you irrespective of your needs. If you missed something, contact us for further guidance. Also, feel free to apply for a loan today if you are looking for an affordable loan.

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