What is Effective Interest Rate on Loan? Your Ultimate Guide to Singapore’s Money Matters
September 19, 2023
When you borrow money from a licensed lender in Singapore, you are charged an interest rate. There are two types of interest rates: nominal interest rate and effective interest rate. The nominal rate is the stated annual interest rate you see when borrowing money from a financial institution.
While most people are familiar with the advertised annual interest rate, only a handful of borrowers understand Effective Annual Interest Rate (EAR). The two figures can be significantly different, but only EAR reflects the true cost of a loan.
So, what is the effective interest rate on loans? Look beyond the nominal annual interest rate before taking out a personal loan. This article covers everything you need to know about EAR to help you get a more accurate figure of the cost of borrowing.
Effective Annual Interest Rate (EAR) In Singapore
Effective Annual Interest Rate (EAR) is the annual interest rate that considers the effects of compounding over the year. It reflects what you’ll actually pay in interest when the interest rate compounds multiple times a year.
In addition to loans and lines of credit, effective annual interest rates may apply to investments and savings accounts. Effective Annual Interest Rate (EAR) is also known as Annual Equivalent Rate (AER) in the Singaporean financial context.
Understanding the Effective Annual Interest Rate (EAR)
Effective annual interest rate provides Singaporean investors and borrowers with a more accurate reflection of the true interest rate being paid. It tells you exactly how much interest you’ll accrue on a loan or an investment based on how often it compounds.
The main difference between effective annual interest rate and nominal annual interest rate is that the latter doesn’t account for intra-year compounding. Here’s an example, say you get two personal loans from a Singaporean lender. Both loans have an annual nominal interest rate of 10%.
However, one of the loans compounds quarterly and the other annually. The effective annual interest rate for the loan that compounds quarterly will be higher even though both loans have an advertised interest rate of 10% p.a.
Calculation of EAR for Singaporean Financial Products
Knowing how to calculate EAR is essential for Singaporean borrowers or investors. You can accurately compare loan offers, investments, and other financial products with different compounding periods to determine what saves — or earns — you the most money.
You’ll need two variables to calculate EAR for Singaporean financial products. These are:
- i = Nominal interest rate
- n = Number of compounding periods
Here’s the formula: EAR=(1+i/n) n−1
The n value will be:
- 1 for annually
- 2 for semi-annually
- 4 for quarterly
- 12 for monthly
- 365 for daily
Using the example in the previous section, let’s calculate the EAR of a personal loan with a stated annual interest rate of 10% compounded:
Effective Annual Interest Rate = (1 + 0.1 / 2)2 – 1 = 0.1025 or 10.25%
Effective Annual Interest Rate = (1 + 0.1 / 4)4 – 1 = 0.1038 or 10.38%
Effective Annual Interest Rate = (1 + 0.1 / 12)12 – 1 = 0.1047 or 10.47 %
As you can see, Effective Annual Interest Rate (EAR) will always be higher than the stated annual interest rate. EAR also increases with the frequency of compounding periods. In other words, EAR will be higher if a loan, investment, or savings account is compounded more often.
Applications of EAR in Singapore
Effective Annual Interest Rate gives Singaporean borrowers, investors, and savers an accurate way to determine true interest rates
Loans and Credit Cards
EAR is an effective tool for calculating the actual amount you’ll actually end up paying in interest for loans and credit card debt. You can use EAR to compare different loan offers and figure out which one will cost you the least.
For instance, say you’re considering two loan offers with the same annual nominal interest rate, but with one of them compounding more often. By calculating EAR, you’ll find that the loan that compounds more often costs more, therefore, you should opt for the other option.
The same applies to credit cards. Credit card companies usually have high advertised interest rates. But as you know by now, that’s actually not the interest you’ll end up paying for using the credit card. You can calculate EAR to find out the true cost of carrying a balance on your credit card.
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You can use EAR to evaluate the true return on investment and then compare the returns on different investment opportunities. By computing the EAR of each investment, you can determine which investment offers the highest rate of return.
Singaporean investors can analyse all kinds of investments using EAR, from stocks to bonds and other investment vehicles. The difference between the EAR of each investment may seem negligible at face value but they tend to add up over time, adding a substantial sum to your overall wealth.
The interest rate on a savings account determines how much you earn by keeping your money in the account. However, the quote rates don’t usually reflect the true return you can expect. You can use EAR to make a fair comparison between products and their advertised rates.
Differences Between Nominal and Effective Interest Rates in Singapore
Annual nominal interest rates and effective annual interest rates often come up in the Singaporean financial scene. Understanding the differences between them can help you make informed decisions when borrowing money or making an investment.
Singaporean banks and other financial institutions often state interest rates as annual percentages. Nominal interest is the rate of interest quoted on a loan or investment product. Effective interest rate is the interest that’s actually earned.
The main difference between nominal and effective interest rates in Singapore is that the latter accounts for the compounding effect while the former doesn’t.
Effective annual interest rate can only be determined when compounding is done more frequently than annually — usually monthly, quarterly, or semi-annually.
Nominal interest rate does not account for true inflation. On the other hand, the effective annual interest rate is adjusted for inflation. For this reason, effective interest rate is deemed a more accurate measure of interest rate.
There’s no formula for nominal interest rate as it’s chosen by the bank. If the financial institution says that a loan has 5% interest, you’ll have to pay S$50 in interest for every S$1000 you borrow. You can calculate EAR by making the effective period equivalent to the compounding period.
Effective annual interest rate is always higher than the nominal interest rate. That’s because EAR takes into account all the costs associated with the financial product, including processing fees, inflation, brokerage fees, etc. Nominal interest rate does not account for any fees or charges.
Factors Affecting Ear in Singapore
Interest rates are always changing. Here are some of the factors that contribute to the fluctuation of effective interest rates in the Singaporean financial sector.
Compounding frequency is the number of times interest is calculated and added back into the principal amount. Effective annual interest rates increase with compounding frequency. In other words, you’ll end up paying or earning more interest if it’s compounded more often.
The duration of the loan can influence the EAR, especially in the context of Singapore’s housing loans. Shorter-term loans tend to have a lower EAR and overall costs.
Demand and Supply
The demand and supply of money is one of the biggest factors affecting EAR in Singapore. When there’s a low demand for credit, financial institutions lower their interest rates to attract borrowers. When there’s high demand for borrowing, interest rates go up.
The government — through the central bank — often uses interest rates to influence economic policy. The central bank can lower or increase the interest rate to stimulate the economy or manage inflation, affecting EAR. These changes can influence credit card holders, borrowers, and mortgage holders.
Inflation is a major contributing factor to effective interest rate fluctuations. If there’s a spike in the country’s inflation, interest rates will likely follow suit. Similarly, lower inflation will also lead to lower interest rates.
Strength of the Economy
A strong economy with low unemployment leads to higher demand for goods and services. The demand for credit also increases as businesses borrow more money to meet this demand, causing effective interest rates to rise — and vice versa.
Limitations of EAR in Singapore
EAR offers numerous benefits over other interest rate metrics, but it’s not perfect. For instance, EAR assumes a constant interest rate and no additional transactions during the year. However, interest rates are constantly changing, affecting total returns.
Also, EAR might not account for fees or other costs associated with Singaporean financial products, which can have an impact on overall returns. Lastly, EAR is not ideal for short-term investments, which limits the vehicles Singaporean investors can calculate using EAR.
In summary, understanding the Effective Annual Interest Rate (EAR) is essential in navigating Singapore’s financial landscape. While the nominal interest rate is commonly advertised, it’s the EAR that accurately represents borrowing costs or investment returns, factoring in compounding effects. By calculating EAR using the provided formula, you can make informed comparisons across different financial products. Keep in mind that while EAR has its limitations, this knowledge empowers you to make more sound financial decisions aligned with your goals.
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