Whenever a loan is being taken, we realise that many people are confused about the interest rate that they are paying. There are a few reasons for this.
The main reason is that people often look at the advertised interest rate is, as opposed to the actual interest rate that they will be paying for taking a loan. This is a crucial mistake, since the advertised interest rate is very rarely the actual interest rate borrowers will be paying.
Thus, we should all have a proper discussion of “Advertised Interest Rate” vs “Effective Interest Rate”.
In this article, we will explain the key differences between the two, what most people are confused about, and why this matters if you are intending to take a loan.
Let’s Start With A Hypothetic Example: Borrowing From A Friend
To understand the concept of advertised interest rate vs effective interest rate, let’s first take a look at a hypothetical example where we borrow money from a friend.
In this example, we need to borrow $12,000. Both parties mutually agree on the borrowing rate of 10% per annum (p.a). This means our interest cost will be $1,200.
Because neither of us are financially savvy, we may simply agree that the interest payment can be made either at $100 per month, for 12 months, or $1,200 at the end of the year. We think it’s the same thing (it’s actually not, but for now, let’s just assume it is).
Here’s an example of how the repayment schedule could look like.
|Month||Monthly Repayment||Annual Repayment|
At the end of the year, a total of $13,200 will be repaid: $12,000 (principal) plus $1,200 (interest). We got the loan we needed while our friend received the promised 10% interest. Everyone is happy.
But what happens if a bank wants to earn the same amount of interest?
What Is Advertised Interest Rate
If a bank wants to earn the same 10% interest, there are two possible scenarios in which they can lend us money.
Scenario A: The bank lends you $12,000 for one year at an interest rate of 10%. They expect the principal ($12,000) plus interest ($1,200) to be repaid at the end of one year.
Calculation wise, this is easy. We will pay the bank $12,000 (amount borrowed) plus $1,200 (10% of $12,000) for a total of $13,200. In this case, the “interest rate” of 10% will be similar to what the bank’s advertised interest rate (10%) is and also the effective interest rate (10%).
|Interest Rate||10% p.a.|
|Advertised Interest Rate||10% p.a.|
|Effective Interest Rate||10% p.a.|
Sounds simple? As it should be.
Now let’s explore an alternative scenario.
Scenario B: The bank lends you $12,000 for one year at an interest rate of 10%. They expect a monthly repayment of the principal plus interest over the next 12 months.
The only difference is that in Scenario B, repayment of the principal and interest is made over a period of 12 months, as opposed to one lump sum at the end of the year.
However, the repayment schedule looks very different now.
|Month||Principal Repayment||Interest Repayment||Total Monthly Repayment|
Based on the same interest rate of 10%, the monthly repayment is $1,054.99. This comprises of a principal repayment of $1,000, and an interest repayment of $54.99 each month.
What’s Our Effective Interest Rate?
By using this repayment method, we can calculate our effective interest rate to be 10.47%, and not 10%.
* This is assuming there are no additional processing or admin fees chargeable
What’s The Advertised Interest Rate?
What’s more interesting and worth noting is what the advertised interest rate will be.
As the table above shows, the total interest payable is $659.89. Typically, the bank will advertise this “advertised interest rate” as 5.5%. This is done by taking the total interest payable ($659.89) as a percentage of the initial amount borrowed ($12,000).
$659.89/$12,000 = 5.5%
Hence, we get the following.
|Effective Interest Rate||10.47%|
|Advertised Interest Rate||5.50%|
Wait…Why Is The Difference So Much?
How can a simple interest rate of 10.00%, with an effective interest rate of 10.47%, end up being advertised at 5.50%?
This huge difference is likely to surprise many who are not familiar with how interest rates are usually calculated for loans.
The reason for this is because even though the bank originally loans us $12,000, we don’t actually have the sum of money for the entire year. From the first month onwards, we are repaying the principal amount borrowed, with interest, to the bank. By the six-month, about half of the loan amount has already been repaid.
The banks use what could be considered by some as a slightly flawed method to determine the advertised interest rate because it uses the total interest payment made, and divide it against the amount that it lends you at the start of the loan period.
This Is Kind Of Complicated. As A Borrower, What Do I Have To Know?
Thankfully, according to the Code For Advertising Practice for Banks in Singapore, any interest-bearing loan must include the effective interest rate. This can be a life-saver, since calculating it involves a really tedious process which includes a complicating mathematical formula.
The effective interest rate on a loan takes into account additional fee such as processing fee and any other service fee which the banks charge us. In other words, it’s the interest rate which you actually pay for taking the loan.
Logically, you should always choose a loan with the lowest effective interest rate. This is because you will be using your money in the most economical way. Advertised interest rate stated may not be very useful making comparisons, as they can be calculated using various methods, some of which may not make much sense.