Everybody knows what an interest rate is – it’s effectively a percentage of an amount over a year. If your savings account earns you a 0.05% interest per year (which is a REALLY terrible interest rate, honestly), you earn $5 in interest for every $10,000 you’ve saved. A year.
But when it comes to bank loans, you often see TWO interest rates: the advertised interest rate, and something called effective interest rate, or EIR.
So why are there two interest rates? And what’s the difference between effective interest rate and the advertised interest rate?
What does Effective Interest Rate (EIR) mean?
EIR, or effective interest rate, is meant to reflect the true cost of taking a loan in Singapore.
That’s because the loan interest rate is not the only cost. There are often also other costs, such as the administration fee that a bank may charge.
Most importantly, though, it looks at how long the loan tenure is and how frequently you pay back the loan. That’s because the effective interest rate also considers the effect of compounding. We’ll provide the formula later in the article.
Currently, all financial institutions in Singapore are required by law to publish the EIR of their loans. That’s why you often see both the Effective Interest Rate as well as the advertised interest rate.
Insisting on EIR means that financial institutions that lend you money, such as banks or licensed moneylenders, cannot rely on attractive interest rates and slip in hidden fees or offer you unreasonable repayment schedules.
Why is EIR higher than the advertised interest rate?
Typical interest rates only look at how much interest you are charged. If you’re taking a $4,000 loan at 5% interest per annum, you should expect to pay a total of $200 in interest each year. But EIR considers all other factors.
For example, if there’s an administrative fee or processing fee, you could effectively be paying more than that.
Let’s say you’re charged a 1% administrative fee on a $4,000 loan. That’s $40. That means you now must pay back $200 in interest AND $40 in fees, for a total of $240. Essentially, you’re paying back 6% of your principal amount.
And that’s just one factor in the calculation. EIR also looks at what it’ll be like to repay the loan. It takes into consideration:
- Number of instalments
- Frequency of instalments
- Whether the instalment amounts are equal or not.
All these factors together are known as the repayment schedule.
How does repayment schedule affect EIR?
Let’s look at different repayment schedules for a loan of $4,000 over a year. Let’s assume the advertised interest rate is 5% per annum. Here’s how different repayment schedules can affect EIR:
|Number of instalments||Frequency of instalments||Amount of instalment||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%|
Now all the above repayment schedules all pay back the same amount of $4,200 in a year. So why are the effective interest rates different?
Simply put, the earlier you start making repayments, the higher the effective interest rate. Think of it as the value of liquidity. The sooner you must repay the borrowed money back, the less you have available to use.
How do we calculate effective interest rate?
It’s going to get a little complicated here, so feel free to skip this section if math bores you.
Here’s the effective interest rate formula:
1 + (nominal interest rate / number of compounding periods)) ^ (number of compounding periods) – 1
Wait! Don’t close this tab just yet. Let’s try break all these terms down.
For most loans, the “compounding period” is a month. Where it gets frustrating is the “nominal interest rate”. You’d expect this to be the advertised interest rate that the bank provides, but it isn’t. For the purposes of calculating EIR, the nominal interest rate is the internal rate of return on the balance of your loan.
… I told you it was frustrating.
Note that this formula for EIR doesn’t include additional costs like admin fees. In the EIRs provided by the banks, they will have been included.
This is exactly why ensuring that EIR is so important, especially when banks are offering different loan packages of different interest rates depending on the length of loan tenure. EIR provides a standardised method of comparing multiple loan options on the same playing field.
Are there online EIR calculators you can use?
If you wish to do your own EIR calculations, the Ministry of Law provides an Excel-based EIR calculator that’s pretty easy to use. All you need to do is key in the:
- Loan amount
- Frequency of instalments
- Number of instalments
- Amount of each instalment
There’s even the option to enter unequal instalment amounts if necessary, though you can only enter up to 12 instalment amounts.
So, should you always go for the lowest EIR?
In general, yes, it’s smart to go for the lowest EIR. The whole point of EIR is to ensure you get the lowest interest rate for your loan, regardless of what the bank advertises the interest rate to be.
However, there are 2 things you must look out for:
1. How much interest you’ll end up paying in total
Very often, a longer loan tenure means a lower EIR, since you repay a lower amount each month. However, when you look at the big picture, a longer loan tenure also means paying more interest overall.
Here’s a simple illustration of two people who borrowed the same amount of $5,000 at the same advertised rate of 5% per annum.
|Number of instalments||36||60|
|Amount of each instalment||$159.72||$104.17|
|Effective interest rate||9.72%||9.55%|
|Total interest payable||$749.92||$1,250.80|
|Total amount payable||$5,749.92||$6,250.80|
As you can see, Anya had the lower EIR and paid less per month, but she pays almost $500 more than Cindy in interest in the end. A lower EIR does not mean you pay less interest altogether.
2. Whether you can afford the monthly repayments
Sometimes, banks may offer you a loan with a lower EIR for borrowing for a shorter tenure from them. However shorter tenures also mean a higher monthly repayment. Not a good idea if you have cashflow issues.
Remember, if you’re unable to repay a loan in full and on time, you’ll incur fees and charges and even a higher interest rate on the outstanding balances.
No point getting enticed by a lower effective interest rate if you’re going to end up paying more than you expected.
Did we miss out anything about effective interest rates in our article? Let us know what else you want us to cover.
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Tags: Personal Loans