If you’ve ever taken out a personal loan or explored loan options, you’re likely familiar with the concept of interest rates. However, when it comes to loans, there are typically two types of interest rates: the advertised rate and the effective rate (EIR). In this article, we’ll delve into the difference between these two rates and why they vary.
What Does It Mean When a Rate is Advertised?
The advertised rate, also known as the nominal rate, is the rate at which the lender charges interest on the borrowed money. There are two categories of advertised rates:
- Flat Rate:
A flat rate loan maintains a constant interest rate throughout the loan’s term. This type of rate is commonly used for loans like vehicle loans and personal term loans. Here’s an example to illustrate the difference between a 5-year and 8-year car loan with a monthly flat rate of 2.5 percent:
While the monthly payment for the 8-year loan is smaller, the total repayment amount is higher.
- Monthly Rest Rate:
The monthly rest rate calculates interest based on the outstanding loan balance. As you repay the loan, the balance decreases, resulting in lower interest amounts over time. This type of rate is commonly used for home loans. Consider a S$600,000 loan with a fixed interest rate of 3.5 percent per year and a 20-year repayment period:
As you can see, the monthly interest decreases as the loan balance is paid off over time, resulting in a decreasing monthly repayment amount.
What is the Effective Interest Rate (EIR)?
The effective interest rate (EIR) represents the actual cost of the loan and takes into account additional expenses such as administrative or processing fees. It also considers the compounding effect, influenced by the loan’s length and repayment frequency.
When comparing different loan packages, it’s crucial to consider the EIR as it reflects the true cost of the loan. The EIR incorporates factors beyond the advertised interest rate, providing a more comprehensive view of the loan’s affordability.
What Makes Effective Interest Rates Higher Than Advertised Rates?
The disparity between advertised rates and EIR arises due to additional fees imposed by banks and licensed moneylenders. These fees, combined with the loan’s interest charges, increase the overall amount owed to the financial institution. Administrative or processing costs are examples of such fees.
For instance, a S$5,000 loan with a 5% interest rate and a 1% administration fee would result in an effective interest rate of 6%. While administrative fees are one factor that affects the EIR, other aspects include the loan’s maturity, installment frequency, and whether the installment amounts remain the same.
How to Calculate the Effective Interest Rate
To calculate the EIR, use the following formula:
EIR = [(1 + (nominal interest rate / number of compounding periods))^number of compounding periods] – 1
For most loans, the compounding period is one month. Remember that the nominal interest rate is not the same as the advertised rate. The EIR calculation incorporates the loan’s internal rate of return.
While the EIR calculation doesn’t include additional costs like administrative fees, financial institutions already account for such fees in their EIR calculations. Online EIR calculators are available if you want to calculate the EIR yourself but are unsure about the formula to use. These calculators require inputs such as the nominal interest rate, loan period, and payment frequency.
Is It Always Best to Choose the Loan with the Lowest EIR?
In general, it is advisable to select the loan with the lowest EIR as it indicates the lowest cost. However, there are other factors to consider before deciding on a loan solely based on its EIR.
- Total Interest Amount:** Although a lower EIR generally means paying less interest, the loan’s total interest amount is influenced by factors such as the loan’s maturity. A longer loan tenure may result in lower monthly payments but higher total interest paid.
- Affordability of Monthly Repayment:** Loans with lower EIRs may require larger monthly payments. Before opting for a loan with a shorter term and lower EIR, ensure that the monthly repayment amount is financially manageable. Defaulting on payments or struggling to make monthly repayments can lead to penalties and higher interest rates.
Consider these aspects alongside the EIR to make an informed decision. Remember, taking on any loan requires careful evaluation of your financial situation and repayment capacity.
For personalized guidance and competitive loan options in Singapore, contact SGP Credit:
Contact SGP Credit:
Phone: +65 6466 1157