What Is Effective Interest Rate On Loan And How Is It Calculated?

Personal Finance

What Is Effective Interest Rate On Loan And How Is It Calculated?

March 16, 2023

Considering to take a personal loan? The interest rate is one important factor to consider when evaluating what loan is best for you.

Interest rate, in general, is nothing but the cost of borrowing money and is expressed as a percentage.

If you have done quite some research or enquiry about loans, you might probably have come across two different interest rate terms, one is the advertised interest rate, and the other is what’s known as EIR or effective interest rate.

But what is effective interest rate on loan, why should you about it and how is EIR calculated? Simply read on.

What Is The Simple Interest Rate?

The simple interest rate is what most advertisements, websites and promotional material will indicate as the loan’s interest rate. It represents what you’ll pay for borrowing the money in terms of percent per year.

For example, if you take a loan of $1000 for a year at a 10% simple interest rate, you will have to pay back $1100 (the borrowed amount + 10% of the borrowed amount).

This flat rate or nominal rate does not take into account what is known as compounding, which can affect the total amount of money you have to pay back in the end.

From the above example, if there is a processing fee of $100 attached to the loan, the simple interest rate will still remain at 10% even though you’ll have to pay back a total of $1200 ($1000 borrowed amount + 10% in interest + $100 processing fee).

What Is EIR?

EIR or effective interest rate on loans is what most financial institutions will use to depict the total cost of borrowing money. In other words, it takes into account all the other fees and charges associated with the loan.

This is what you should really pay attention to when comparing loans, not just what’s indicated as the advertised interest rate.

The EIR depends on how long you want to take the loan and how frequently you pay the loan.

Singapore law currently requires all financial institutions to express loan interest rates in EIR, so you can be sure what the total cost of borrowing money will be.

If you are still confused about what is EIR, then you can use EIR calculators Singapore to find what the effective interest rate on loan will be when taking into account all fees, charges and compounding.

Why Are Effective Interest Rates Typically Higher Than Advertised Rates?

Effective rates are typically higher than advertised rates as they take into account compounding as well as other fees and charges associated with the loan. This is what makes up the effective rate of borrowing money.

In simple interest rates, only the flat rate of borrowing is taken into account, and not what you have to pay eventually.

So, if you want to find out what the real cost of borrowing money will be, then EIR is what you should pay attention to.

To understand better, here is an example.

Let’s say, you are getting a loan of $3000 at the simple interest rate of 4%. On first thought, this may mean you will have to pay back $3120 (the borrowed amount + 4% of the borrowed amount).

But, when considering effective interest rate calculation, you’ll find that the EIR could be much higher than what’s indicated with the simple interest rate.

This is because other charges like processing and administrative fees are factored into the total cost of borrowing. Let’s say, you have 1% of admin fees and processing fees. That would make the EIR to be 5%, and the total amount of money you have to pay back is $3150.

How To Calculate Effective Interest Rate

You may now have an idea of What is EIR. But how to calculate the effective interest rate?

Here is the EIR formula:

EIR = [ ((nominal interest rate / no. of compounding periods) ^ No. of compounding periods)+1 ] – 1

Here the nominal interest rate is what is advertised as the simple interest rate.

The compounding period depends on what frequency you want to payback the loan (monthly, quarterly, etc.)

So, if you are taking a $3000 loan with a simple interest rate of 4% compounded monthly,

EIR = [( (4/12)^ 12) + 1 ] – 1

EIR = 4.2%

If this is confusing for you, then you can make use of the EIR calculator Singapore offers to get an accurate calculation.

How To Choose The Best Loan

Now that you know what is EIR and how to calculate it, you can make more informed decisions when choosing the best loan.

Here are a few things that you must consider when choosing a loan:

Check EIR

Make sure to check what the effective interest rate on loan will be before signing off. Only then will you know what the total cost of borrowing money will be? You can use the EIR calculator Singapore to get an accurate calculation.

Always remember, bluntly going for the lowest EIR doesn’t mean you are getting the best loan. The actual amount you may pay may vary depending on the loan amount and the loan structure.

Look For Other Fees And Charges

Beyond EIR, make sure to check the other charges associated with the loan like processing fees, late payment penalties etc. Any additional charges should be checked so that you can plan your budget accordingly.

Check Repayment Terms

Checking what repayment terms work for you is also important. Make sure to check what frequency the loan needs to be paid and what would happen if you are unable to pay it back within the period.

Also, longer tenure loans usually have lower EIR as you might be paying less every month.

However, even with a lower monthly EIR, the total cost of borrowing money can be high. So, make sure you calculate what EIR will be using EIR calculator Singapore before signing off.

Is The Repayment Amount Affordable?

Lastly, make sure that you check what the repayment amount will be after calculating what is EIR and other factors. This is important to look at what your budget would be like if you take the loan. That way, you can choose what works best for your financial situation.

By considering these factors, you can easily decide what loan works best for you and make informed decisions.

Get The Best Effective Interest Rate

In order to get the best loan, you need to know in detail about the effective interest rate.

Hope this article has helped you understand what is EIR, how to calculate it and what to consider when choosing the best loan.

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