If you’ve ever considered taking up a personal loan, or even a car loan, renovation loan or instalment plan, you would likely see two different rates being advertised on the same loan by many financial institutions. Whether highlighted in the same font size or as a footnote, the effective interest rate (EIR) on your loans will be much higher than the simple interest rate or the advertised interest rate.
With interest rates on the rise, this can be an even more costly mistake if you read or think the interest rates would be calculated at a lower rate.
What Is The Simple Interest Rate?
The simple interest rate is the interest rate that the bank charges you for taking the loan. It is also commonly known as the flat rate, nominal rate or advertised.
To simplify the calculation for you, we take the following scenario as an example:
Loan amount: $100,000
Tenure: 10 years
Processing fee: $2,000
Simple interest rate: 10% per annum
If you take out such a loan, you firstly get $98,000 in hand as the $2,000 processing or administrative fee will typically be taken at the point of issuing the loan. In technical terms, it’s front-loaded.
Next, you have to pay an interest rate of 10% on your $100,000 loan every year, for the next 10 years. You also have to pay another $10,000 every year, for the next 10 years, to pay down your principal amount.
While many of us understand interest rates in this manner, it does not take several things into consideration – 1) any “administrative” or “processing” fee that we’re not sure why we’re paying and 2) the fact that we’re paying down our principal amount each year and are actually borrowing less after each month. This is where the effective interest rate comes in.
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What Is The Effective Interest Rate?
The effective interest rate or EIR on a loan takes into account any processing fee and the fact that you’re also paying back part of the principal that you borrowed every month but still have to pay an interest rate based on the initial sum you borrowed.
Given the same scenario above, this means you have to take into consideration that you’re paying an interest rate on a $100,000 loan but receive only $98,000 from the start. Further, you also have to consider that your loan amount is lower after each monthly repayment that you make. Hence, your interest rate is actually higher since you’re making payments based on a $100,000 loan, but have a lower remaining amount of loan.
To give you some perspective on the situation, in the 10th year of your loan, you would have already repaid over $90,000 and have only $10,000 left on the loan. Yet, you have to make interest payments on a loan of $100,000.
Effective interest rates aim to give you a fuller picture by taking these things into consideration. And, in the same scenario above, you’ve actually been paying for a loan of $100,000 when you only got an initial loan of $98,000. This translates to an effective interest rate of over 17% per annum.
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Why Is The Effective Interest Rate Important?
If you think about it, when a company sells a bond, the company pays a year coupon rate but none of the principal. They will only repay the principal when the bond matures. This means that the company is making full economic use of the entire principal until the end of the bond.
As an individual taking a loan, you’re not really in the same position. You’re repaying part of the principal to the financial institution every month. This means you’re not making full use of the entire principal for the duration of the loan, and hence why the effective interest rate is actually higher for you.
Another important thing to note is that while the financial institution is charging you for that loan, it has already received part of its principal back, and can proceed to give out more loans with the same money.
At the end of the day, the effective interest rate just tells you the price you’re economically paying for the loan.
How To Find Out The Effective Interest Rate On A Loan
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 as calculating it involves a really tedious process which includes a trouble mathematical formula.
In a logical sense, 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. Any simple interest rate (or advertised interest rate or flat interest rate) stated may not make for a good comparison as they can be calculated in various methods.
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This article was originally published on 10 January 2018 and has been updated with new information.
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