What Is Effective Interest Rate On Loan And How Is It Calculated?
March 21, 2023
Most people know the meaning of the term “interest rate,” defining it as the percentage of a given amount over a year. If your bank gives you an interest rate of 0.1% on the amount in your savings account, you earn $1 on every $1,000 you save per annum.
However, suppose you’ve thought about applying for any kind of loan and enquired about it. In that case, you must’ve come across two different interest rates – the simple interest rate and the effective interest rate (EIR).
In this guide, you’ll learn what is simple interest rate, what is effective interest rate on loan, the differences between the two, how to calculate EIR, and more!
What Is The Simple Interest Rate?
The simple interest rate is the interest rate the bank charges for taking out the loan. It’s also known as the advertised interest rate, nominal rate, and flat rate.
To help you understand, let’s look at the following example.
- Loan Amount: $100,000
- Loan Tenure: 10 Years
- Processing Fee: $2,000
- Simple Interest Rate: 10%
When you take out a loan with the above specifications, you receive $98,000, as the processing fee is deducted automatically upon loan approval.
Subsequently, you need to pay an interest of 10% on an amount of $100,000 per annum for the coming ten years. On top of that, you must pay another $10,000 per annum for the same ten years to repay the principal loan amount.
Although most of you understand interest rates in terms of simple interest rates, it doesn’t consider the following things:
- You end up paying interest on the processing or administrative fee that gets deducted from the principal loan amount.
- You’re effectively borrowing less and less each month after successfully repaying a portion of the principal loan amount every year. But you’re still paying interest on the entire loan amount you borrow at the beginning.
Now that you’re familiarised with simple interest rates, let’s move on to understanding the effective interest rate on loan.
What Is EIR?
Unlike the simple interest rate, EIR, or effective interest rate, reflects the actual cost of taking out a loan in Singapore. This is because the interest on the principal amount isn’t the only cost you bear. There are other costs that the advertised interest rate doesn’t consider, such as the administrative or processing fee.
Moreover, the effective interest rate also takes into account the fact that you’re paying back a part of the principal amount in every installment but also paying interest on the initial amount.
Considering the above loan scenario, the effective interest rate will be calculated based on $98,000 as the principal amount instead of $100,000 – due to the deduction of processing fees.
The effective interest rate will also be adjusted to reflect that your loan amount reduces after every monthly repayment.
Simply put, while going into the 10th year of the above loan, you’d have already paid $90,000 and have $10,000 left on the principal loan amount. Nevertheless, you’ll still have to pay interest on the initial sum, i.e. $100,000.
Understanding the concept of effective interest rate is one thing, but calculating it is another. The next section will teach you how to calculate the effective interest rate.
Comparing numerous loan packages and their interest rates can be overwhelming. Contact financial experts at GS Credit, who will tackle all loan complications and tailor customized loan packages based on repayment terms of your choice!
How To Calculate Effective Interest Rate?
The formula to calculate the effective interest rate on loan is as follows:
EIR = (1 + i/n)n – 1
In the above equation, “i” is the annual nominal interest rate and “n” is the number of compounding periods.
For most loans, the number of compounding periods is equal to one, which is pretty simple. However, the nominal interest rate in the EIR formula isn’t the same as the simple interest rate. In reality, the internal rate of return on your loan is the nominal interest rate.
Note: The above formula to calculate the effective interest rate doesn’t include additional costs like processing fees. But, such charges will be included in the EIR provided by the banks and money lenders.
Effective interest rate calculation can be a bit complicated, but there’s no need to lose your mind over the formula, as you can find several EIR calculators for Singapore online!
Are EIR Calculators Available Online?
Fortunately, according to the Code For Advertising Practice for Banks in Singapore, any loan consisting of interest payments must include the effective interest rate. This eliminates the need for you to go through a complex process of calculating the EIR with the help of a confusing mathematical formula.
Nonetheless, if you’re looking for customized loan packages, you might need to calculate the EIR to select the most suitable one.
Thankfully, the Ministry of Law offers an Excel-based EIR calculator that’s incredibly easy to use. All you need to do is input the following parameters:
- Loan amount
- Frequency of installments
- Number of installments
- Amount of each installment
You can input unequal installment amounts, but the number of installments for the same is limited to 12.
Why Are Effective Interest Rates Typically Higher Than Advertised Rates?
Effective interest rates are higher than advertised or simple interest rates because the latter only look at how much interest the banks charge you.
For instance, if you take out a loan of $4,000 at an interest of 5% per annum (advertised rate), you’ll have to pay an interest of $200 every year. On the contrary, EIR considers other factors, such as the ones mentioned above.
Let’s assume you’re charged a processing fee of 1% on the $4,000 loan. Subsequently, you’ll pay $240, including $200 in interest and $40 in processing fees. As a result, you’re paying back 6% of your principal amount, which equals the effective interest rate.
Hence, when you consider factors like additional costs, the number and frequency of installments, and whether the installments are equal, the effective interest rate turns out greater than the simple interest rate.
How To Choose The Best Loan
The best loan is commonly the one with the lowest effective interest rate. After all, the whole point of EIR is to help you get the lowest interest rate on your loan regardless of the advertised interest rate.
However, even if a loan package has a lower EIR, you must consider the following two factors before deciding:
1. What Is The Total Interest You’ll Be Paying?
Since you’re paying a lower monthly amount, a longer tenure will imply a lower EIR. But, on the other hand, a longer term means you’ll have to pay more interest.
You should remember that a lower EIR doesn’t always mean you’ll be paying a lower interest in total, as there are other determining factors.
2. Are You Capable Of Repaying The Monthly Installment Amount?
Sometimes banks will offer you a loan with a lower EIR when you borrow for a shorter tenure. Although short-term loans encompass lower interest payments, they also mean a higher monthly repayment amount, which isn’t ideal if you have an unsteady income.
Loans With Lower EIR Are Better But Not Fool-Proof
A lower effective interest rate means the loan will be less expensive overall.
However, it’s also essential to consider the loan terms, such as the repayment period, loan amount, and the lender’s reputation and customer service. Some lenders may offer low effective interest rates but make up for it with hidden fees or less favourable loan terms.
Ultimately, the best loan for you will depend on your financial circumstances. Now that you know the effective interest rate on loan, it’s important to carefully compare different loans and consider all the relevant factors before making a decision.
If you’re planning to take a loan, get in touch with GS Credit, one of Singapore’s most reputed and trusted licensed money lenders. They provide loans with low effective interest rates, superfast approval, and minimum paperwork. Apply for a loan today to catch the best deals.