Is Higher Effective Interest Rate Better?
In getting a bank loan it is important that you are aware of the important difference between the advertised interest rate and the effective interest rate.
Awareness of this distinction would give you better insights on the expense that you are incurring in relation to loans that you decide to avail. But aside from this, it is also important to know about how the level of the effective interest rate affects the total amount that you have to pay.
A low effective interest rate is not automatically good or strategic and a high effective interest rate is not necessarily always a bad thing. In this article, we will learn more about the effective interest rate, specifically about the ideal rate of such in loans.
What Is an Effective Interest Rate/EIR?
Few people who avail bank loans are aware that there are two different interest rates involved. The first one is the advertised interest rate/AIR and the second one is the effective interest rate/EIR. EIR ought to reflect the true cost of a bank loan.
It is important to differentiate between effective interest rate and advertised interest rate because EIR is higher than the AIR. This is because advertised interest rates do not often include other auxiliary costs that are charged by banks and other financial institutions.
The advertised interest rate may also not reflect the effect of the loan tenure. EIR, however, takes into account the length of the loan tenure and the frequency of your payments. EIR includes the effect of compounding in the interest that you have to pay.
Banks may not always post the EIR because they only want to show clients the nominal interest of their loans and not include administrative fees like the processing fee in their computation.
However all financial institutions in Singapore are legally mandated to publish the effective interest rates of their loans. Failing to do so is perceived as dishonesty to clients. This measure protects the consumers from falling victims to the attractive interest rates advertised by financial firms and getting caught off-guard by the actual amount after the effective interest rate calculation which always ends up higher than the advertised.
How to Calculate Effective Interest Rate?
The computation of a typical interest rate is fairly simple. It only takes into account how much interest you are charged for a particular loan amount.
Let us say that you acquired a loan amounting to $10,000 at a 5% interest rate per annum. Your interest rate would therefore amount to $500 per year. Effective interest rate, however considers all factors.
For example, if the moneylender of the financial institution where you took a loan from charges an administrative fee of 1%, then that would be included in the computation. Using the same example, the effective interest rate that you would have to pay is $600 dollars because the administrative fee that costs 1% of the loan amount is $100 added to the 5% annual interest that is $500.
The EIR formula is as follows:
1 + (nominal interest rate / number of compounding periods)) ^ (number of compounding periods) – 1
Do not be daunted. The compounding period usually translates to a month. So if your loan tenure is one year then the number of compounding periods is 12. There are also a number of EIR calculators that can give you a good estimate of your EIR. The Ministry of Law has their online calculator and other websites as well.
These calculators would usually the following details:
- loan amount
- frequency of installments
- number of installments
- amount of each installment
The formula stated above does not include administrative costs yet, but other sample calculators like the one linked above includes it in the calculation.
But aside from the administrative cost, EIR also considers multiple other factors like the number of installments, the frequency of the said installments, and whether the installment amounts are equal to one one another or not.
Taken together, these factors constitute the repayment schedule. To illustrate this, look at the sample table below. This table shows a loan that amounts to $4000 with a 5% interest rate per annum:
Number of Installments | Frequency of Installments | Amount of Installment | Effective Interest Rate |
1 | Once a year | $ 4, 200 | 5% |
4 | Every 3 months | $ 1, 050 | 8.16% |
6 | Every 2 months | $ 700 | 8.78% |
12 | Every month | $ 350 | 9.49% |
The table shows that the earlier you start making repayments, the higher the EIR is.
Other Costs of Loans
- Processing fee– this is paid for the processing of the application. Processing fees are charged upfront upon the approval of the loan.
- Amendment fee– an amendment fee is charged when changes are made in the original loan application.
- Cancellation fee– this fee is charged to clients who did not take up or draw down the loan after accepting its terms.
- Excess charges– these are charged when the clients drew more than the original overdraft limit.
- Late payment charges– these charges are incurred for not paying the amount due by the payment due date due date.
- Default charges– this is charged to a client who failed to make the expected payment
- Early repayment charge– this is paid by a client who opted to pay a part or the whole of the loan earlier than the original date agreed upon.
These costs should be taken into consideration by everyone who decides to take different kinds of loans like bank loans, student loans, credit card loans, renovation loans, and home loans.
Borrowers should take into account these possible additional charges to the nominal rate of their loans. Knowing the total interest helps us to keep track of our personal finance better.
Some banks and lending institutions do not practice advertiser disclosure, so it is always better to practice vigilance so that our hard earned money through working and investing are not wasted on some unforeseen interest, expense, and charges.
What to Keep in Mind When Choosing the Best EIR?
Generally speaking, it is always better to get a loan with a low EIR. However, a low EIR is not automatically a good idea especially when we consider the number of compounding periods.
Sometimes, a longer tenure may equate to lower EIR since you are paying a lower amount of installment every month. However, the overall annual rate or annual percentage of the interest may be higher. Below, you can see a an illustration of two people, Person A and B, who loaned $5000 at an advertised interest rate of 5% per year:
Person A | Person B | |
Loan amount | $5,000 | $5,000 |
No. of installments | 36 | 60 |
Amount of installment | $159.72 | $104.17 |
EIR | 9.72% | 9.55% |
Total interest payable | $749.92 | $1,250.80 |
Total amount payable | $5,749.92 | $6,250.80 |
Closing
it is important to make informed choices when taking a loan and when planning the payment of any incurred loan. This is why, awareness on the difference between the advertised interest rate and the effective interest rate is crucial.
When it comes to the effective interest rate, it is important to be aware of the monthly compounding, the length of the tenure, and the frequency of installments.