When looking for a loan, you can find two interest rates attached to it- the simple rate and the EIR. You can be attracted to a loan package due to its low nominal rate. But did you know that the actual cost of a loan depends on its effective interest rate?
Therefore, asking, ‘what is effective interest rate on loan?’ is a wise decision when you want to take out a loan. It helps you to choose the best loan package in the market.
In this article, you will find a deeper explanation of the effective interest rate, how to calculate it, and why it is higher than the nominal rate. Lastly, you will learn how to choose the best loan.
What Is The Simple Interest Rate?
A simple interest rate is also a nominal or advertised rate. It is the interest a financial institution charges you on the amount you borrow.
Under the simple interest rate, a bank can calculate your interest using a flat rate or a monthly rest rate.
A flat rate means the interest will remain the same for the entire loan term. On the other hand, for the monthly rest rate, a lender will calculate your interest depending on the outstanding loan balance.
This means the interest and loan balance will decrease as you make your monthly instalments.
What Is EIR?
Apart from the simple interest rate, you will find loans with another rate detonated as EIR. As a result, you may be asking, ‘what is EIR meaning?’
EIR shows the actual cost of a loan. It factors all the costs of a loan, including the processing or admin fees. It also considers the frequency of your repayment schedule plus the loan tenure.
Usually, the effective interest rate on a loan is higher than the nominal rate.
Currently, the Code of Advertising Practice for Banks requires all the lenders in Singapore to publish the EIR they are charging on their loans. This is to help you make the right decision and not be swayed by attractive, simple interest rates.
How To Calculate Effective Interest Rate
After knowing what is effective interest rate on loan, you can engage your mind and do some calculations.
So how do you do effective interest rate calculation?
You can do it in two ways:
Here is the EIR formula;
1 + (nominal interest rate/number of compounding periods)) ^ (number of compounding periods) – 1
Note that the compounding period for most loans in Singapore is one month. Also, the nominal interest rate does not mean the simple interest rate; instead, it is the internal rate of return on your loan balance.
The formula does not include additional costs, such as the admin fee. However, you don’t have to worry because lenders will have included it when providing the EIR.
Online EIR Calculator In Singapore
The EIR formula can be frustrating to use.
However, the calculation becomes simpler with an effective interest rate calculator in Singapore. For example, you can use the Ministry of Law Excel-based EIR calculator.
The calculator only requires you to key in the following:
- Your loan amount
- Frequency of the installments
- Number of installments
- The amount you will pay per installment.
You can find other EIR calculators online that can ask you to provide different details. The good thing is that once you key in the details, the EIR calculator in Singapore will automatically generate the rate.
Why Are Effective Interest Rates Typically Higher Than Advertised Rates?
EIR is higher than the advertised rate for one simple reason- the advertised rate only factors the interest you will pay, while the EIR considers additional loan costs. As a result, the total amount you will pay back is higher.
For example, a loan has an interest rate of 5% plus a processing fee of 1%. The advertised rate will be capped at 5%, while the EIR will be 6%.
However, the processing fee is not the only factor that hikes the effective interest rate. It is also affected by the following:
- The loan tenure
- The number of times you will make installments
- The amount you pay per installment.
The above makes your loan repayment schedule. Usually, the more the frequency of installment, the higher the EIR.
How To Choose The Best Loan
When choosing a loan, it is crucial to ask, ‘What is EIR in a loan?’ if you are unfamiliar with this term. It will help you to choose the best deal in the market.
So- how does EIR help to select a loan? Ideally, the lower the EIR, the cheaper the loan. Therefore, selecting a loan package with the lowest effective interest rate is good.
However, the lowest EIR does not always mean the best loan option. You should consider the following when choosing a loan in Singapore;
Total Interest You Will Pay
Selecting a longer loan term will result in a lower effective interest rate because you are paying a lower monthly installment amount. However, the longer the loan tenure, the more interest you will pay for your loan.
Here is an illustration of two ladies who took a $5,000 loan amount at a 5% advertised interest rate per year;
|Number of installments
|Amount per installment
|Total Interest Paid
|Total Amount Paid
From the above table, Anna got a lower EIR and paid a smaller monthly amount than Cate. However, she ended up paying more interest and loan amount than Cate. Therefore, a lower EIR does not always translate to a lower interest.
Monthly Repayments You Can Afford
How much does a lender expect you to pay monthly? You can get a loan offer with a lower effective interest rate for a shorter loan term. But do not be quick to accept such because shorter loan tenure means higher monthly repayment.
Therefore, you need to be aware of the monthly amount you should pay. You can weigh your capability depending on how much you earn per month. Select an amount you can cover without straining or getting into other debts.
Also, remember that when you fail to repay your loan on time, you will attract penalties. Lenders impose a late payment fee and others a higher interest rate. This means you will pay more than you had planned.
All You Need To Know About Effective Interest Rate
Having a good understanding of what is effective interest rate on loan is a step closer to choosing the best loan package.
EIR is the rate that reflects the actual cost of a loan. It factors all the loan aspects, including the administration fee and your repayment schedule.
Knowing how to calculate it is essential too. You can use the EIR formula, which is as follows;
1+ (nominal interest rate/ no. of compounding periods) ^ ( no. of compounding periods) -1.
Also, you can use the effective interest rate calculator in Singapore. It automatically generates the rate once you provide the required details, such as the loan amount, the number of installments, and their frequency.
If you are looking for loans with reasonable interest rates and flexible repayment plans, Credit 21 has you.