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Compare Effective Interest Rates VS Simple Interest Rates For Loans

Calculating effective interest rates CreditMaster

Have you ever taken a loan from your lender and realized that the quoted interest rate on the agreement sounds different from your previous application? Well, lenders use different types of interest rates for different loans.

When making a loan application from a bank or licensed moneylender in Singapore, it’s always good to get clarity on whether the rate is simple interest or effective interest. The difference between the two is very crucial and affects your loan repayment.

Many banks and financial institutions will market their loans to have the lowest rates, but they usually do not explain the interest rates or demonstrate how it is calculated. There is a big difference between effective interest rates and simple interest rates. As a borrower, it is important to do your due diligence before making a financial decision.

What Is Simple Interest Rate?

By a simple interest rate, it means that your loan will accrue interest at a constant rate in every repayment period. It’s the “simplest” form of charging interest in terms of computations and customer understanding. Its also commonly known as flat or nominal rate by different lenders.

The sean the actual amount of interest remains the same during every installment is because it doesn’t facto compound. Compounding is the charging interest on both the principal amount and the interest that has accrued from the previous periods.

Hence, failure to fully settle an installment means some interest amount adds to the principal balance for compounding interest. Therefore, you will be charged interest on interest in the next period.

 

Simple Interest Rate Formula

The formula for a simple interest rate is easy because it only applies to the loan’s principal amount. This interest rate does not multiply by the borrower’s payments, which reduces the amount owed at each period in a payment schedule.

Therefore, the simple interest formula: i = P(rt)=PxRxT

Note: R and T are in the same units of time (e.g., month or year).

 

How To Calculate Simple Interest?

The best way to explain simple interest calculation is with the below example.

Supposing you borrow $50,000, and you are to repay in ten (10) months, your lender charges a simple interest rate of 1 per cent per month. Applying the formula above,  you will calculate the interest rate amount payable as follows;

i = P(rt)=PxRxT

= 50,000 (0.01*10)

= 50,000 (0.10)

=5,000

At the end of the 10 months repayment period your will have earned $5,000 as interest. Simply put, your monthly interest per month remains at $500 whether you pay or not.

With a loan of $50,000, you will need to repay $5,000 every month excluding interest rates. If the interest rate is fixed at 1%/month, you will have to pay $500 in interest monthly. With simple interest rates, you will make a fixed monthly payment of $5,500 until the end of your loan tenure.

 

What Is The Effective Interest Rate?

The effective interest rate is the actual rate of interest that a borrower pays on a loan after any fees or charges are added. It’s, in simpler terms, the actual cost of borrowing money.

The effective interest rate (EIR) also considers the payments made over a given period. Therefore, unlike the simple interest rate, EIR is not applied to the principal amount but on the periodic balance after making payments.

 

Why Is The Effective Interest Rate Crucial?

When you consider the amount of interest payable using the effective interest rate, you will notice that you are paying the actual cost of borrowing. Hence, you are not obligated or burdened to pay interest on the amount you have already paid back to the lender.

However, it’s important to note that the effective interest rate differs from the advertised interest rate. Because it does not include any fees or charges, the advertised rate is usually lower than the actual rate.

 

Effective Interest Rate Formula

When you take a given loan amount and based on EIR per annum, your lender will calculate the monthly loan repayment amount (installment), taking compounding into account.

It’s from this installment that one portion goes to repay the principal amount, and the other goes into interest payment.

Effective annual interest rate = (1 + (nominal rate / number of compounding periods)) ^ (number of compounding periods) – 1.

For instance, if you borrow the same amount of $100,000 from your bank, and you are to repay in a period of ten (10) months. Then, the bank charges you a simple loan interest rate of 1 percent per month, you will calculate the effective interest as shown in the table below;

MonthBeginning Balance ($)Scheduled Payment ($)Principal ($)Interest ($)Ending Balance ($)
1100,000.0010,671.8110,671.811,200.0090,528.19
290,528.1910,671.8110,671.811,086.3480,942.73
380,942.7310,671.8110,671.81971.3171,242.23
471,242.2310,671.8110,671.81854.9161,425.33
561,425.3310,671.8110,671.81737.1051,490.63
651,490.6310,671.8110,671.81617.8941,436.71
741,436.7110,671.8110,671.81497.2431,262.14
831,262.1410,671.8110,671.81375.1520,965.48
920,965.4810,671.8110,671.81251.5910,545.26
1010,545.2610,671.8110,671.81126.54-
Total interest:6,718.06

Notes:

All figures in SGD.

The two cases illustrated show that the total effective interest is $6,718.06, which is far much lower than the simple interest of $5,000 given the same rate of 1% per month and for ten months.

As a result, comparing loans using the effective interest rate is a much more accurate way to ensure you’re getting the best deal.

 

How Will Interest Rates Affect My Loan?

From the discussion above, it is clear that interest rates play a significant role in determining your ability to make periodic loan repayments comfortably. Hence, there are two ways to look at the effect of a rate on your loan. First, it’s good to note that the loan repayment increases with the increase in interest rate.

Secondly, if you get a loan with a fixed interest rate, it means you will continue paying the same installment over the years whether the rates increase or decrease. However, if the rate is flexible and the rates go up, then you suffer with higher payments.

Effective interest rate is used on most loans and by many lenders. It means that interest is calculated on the principal and any accumulated interest from previous periods. Simple interest is highly used on short-term loans as they tend to be unsecured. Furthermore, some loans have variable interest rates, and the formula must be recalculated each time the rate changes.

Make sure to do the math for the cost of borrowing before signing a loan contract. Your personal finances and monthly expenses will be affected due to the loan. To find out more about personal loans or get a quote, click here.

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