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

Dexter Lee February 27, 2023

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

Have you ever wondered why there are two interest rates when you want to take a loan? Whether it’s a personal loan or for business, you’ll be hit with an advertised rate and an effective interest rate.

Since the advertised rate is cheaper than the effective interest rate, you could be tempted to jump in and take a big loan.

But both interest rates have different purposes. The advertised interest rate is cheaper than the EIR because it’s supposed to reel in customers. But the EIR gives you a true picture of what to expect when you take a loan.

So, here’s a guide on what is the effective interest rate on loan and how to calculate it.

EIR Meaning

As we all know, an interest rate is a percentage of an amount over a given period.

On the other hand, EIR is the real cost of taking a loan. It includes the bank or money lender’s administrative fees and other charges attached to your loan.

The Singapore government requires legal moneylenders and banks to show customers the original cost of a loan.

So when you’re taking a loan, you’ll see two interest rates attached. Also, showing what the EIR of a loan is ensures that banks and financial institutions can’t slip in hidden charges to your loan.

The cost of the effective interest rate on your loan is also determined by the principal amount, how often you pay, and compounding interest. So, the longer you owe, the more your EIR increases.

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    What Is The Simple Interest Rate?

    A simple interest rate is what you pay the financial institution when you take a loan. It is the rate attached to the loan in the original agreement terms. You can calculate the simple interest rate on a loan by multiplying the interest rate by the principal amount and the loan term.

    Interest rate x principal amount x term of loan

    The simple interest rate doesn’t include the compounding interest on the loan. It is a fixed amount you can pay off at the beginning of the loan.

    One of the benefits of a simple interest rate is that it reduces the amount you’re supposed to pay back.

    For example, if you take a $20,000 loan with 10% simple interest, you can take only $18,000. It means you have paid off the simple interest and reduced your debt by $2000.

    How To Calculate Effective Interest Rate

    To go straight to the point, here’s the EIR formula:

    1 + (nominal interest rate/number of compounding periods) ^ (number of compounding periods) – 1

    Here’s a breakdown of the formula.

    The nominal interest rate is the interest rate you get before considering inflation. The Singapore Central bank determines this rate.

    It is supposed to encourage people to take out loans, especially after a terrible economic recession. Here’s a formula to calculate the nominal rate:

    n = m × [ ( 1 + e)1/m – 1 ]

    e = effective rate
    m = compounding period

    The compounding period for most loans is typically one month. This EIR formula doesn’t include admin fees and other bank charges. But banks and money lenders include everything you need in their loan handbooks.

    Is There An EIR Calculator in Singapore?

    Calculating what is effective interest rate on loan can be draining and lead to errors.

    To avoid irreversible financial mistakes, the Ministry of Law has an effective interest calculator in Singapore. It is designed in an Excel sheet, and the parameters needed for calculation are

    • Loan amount
    • Number of instalments
    • Frequency of instalments
    • Amount to be paid in each instalment

    The calculator simplifies the effective interest rate calculation and is free to use.

    Why Are Effective Interest Rates Typically Higher Than Advertised Rates?

    Advertised rates are cheaper than effective interest rates because lenders use them to attract borrowers. It is placed on the lender’s website or brochure to reel in clients.

    An advertised rate is determined by factors like credit score, loan amount, and loan term. But this rate can be shortsighted because it doesn’t consider inflation and compound interest.

    You should also remember that the advertised rate isn’t always what you qualify for as a borrower. Sometimes, depending on your credit score, your interest rate will be higher than the advertised rate.

    EIR is higher than the advertised rate because it provides a comprehensive cost of your loan. It covers the processing fee, administrative charges, and other fees attached to getting the loan.

    The effective interest rate on loans also factors in the frequency and amount of interest payments.

    It calculates the total cost of borrowing, including interest and fees, over the loan term. You get this information in the form of an annual percentage, which you can then use to compare what is the EIR in loans of different lenders.

    Difference Between EIR And Advertised Rate

    EIRAdvertised Rate
    It’s not affected by inflationIt’s affected by inflation
    It covers the total cost of borrowing, interest, and fees attached to your loanIt takes only the principal amount and interest rate into account
    It gives you a clear picture of how much you’ll pay backAdvertised rate is for marketing purposes
    Effective interest rate is expensive because it is comprehensiveAdvertised rate is cheap

    How To Choose The Best Loan

    Finding the best loan for yourself can be tasking as different providers provide different interest rates and services. So here are some factors to consider before applying for any loan.

          1. What Is the EIR Of The Lender?

    There’s no fixed effective interest rate, so it can be confusing to pick one lender. But to save your time, it’s ideal to compare different lenders’ rates and opt for the option you can afford. Did you notice we didn’t say to opt for the cheaper option? It’s because a lender’s EIR is not synonymous with good services or a favourable repayment plan.

         2. Is There A Reasonable Repayment Plan?

    Some lenders won’t give you the grace to pay at your pace. The ideal loan term for compounding interest is one month, but some lenders can make it 27 days or less.

    Also, some lenders set unreasonable instalment payments, placing you under undue pressure. So it’s advisable to opt for a lender that offers you a repayment plan that falls within your limits.

         3. Loan Repayment Duration

    Lenders that have shorter repayment tenures tend to have higher interest rates. Due to the shorter number of instalments, it charges more, so it’s not at a loss.

    But lenders with longer repayment terms have cheaper interest rates. So if you’re a low-income earner, opting for companies with longer tenures is ideal.

         4. Foreclosure Conditions

    Sometimes, you can pay your loan before the stipulated time, which is good. But some lenders have different approaches to paying your loan ahead of time.

    Some may charge you up to 5% of the total amount you’re paying at foreclosure. Before closing a deal with any lender, ensure you understand their foreclosure plan.

    Before taking out a loan, ensure you know what you need the money for and have a plan to pay back. Include the loan repayment in your monthly budget so you don’t encounter a financial crisis due to a loan weighing you down.

    Opt For The Loan With The Most Reasonable EIR

    Calculating what is effective interest rate on loan is a daunting task. So it’s advisable to opt for a lender that works with financial experts who show you the effective interest on all loans.

    If you’re wondering where to get one of the best loans with the most affordable EIR in Singapore, consider CreditMaster.

    We offer different types of loans for personal use, small businesses and while you wait for payday.

    Even if you’re an expat in Singapore, you can apply for a loan from CreditMaster to solve your financial needs.

    Dexter Lee

    Born with a pen in one hand and a keyboard in the other, Dexter's been crafting words into beautiful prose since he was old enough to scribble on his walls (much to his mother's chagrin). He's a self-proclaimed pun master, often leaving his coworkers in stitches with his clever wordplay. He's been known to strike up conversations with strangers and turn their stories into captivating content that keeps readers coming back for more. Despite his unconventional approach to life and work, Dexter takes his job as a content manager very seriously. He knows that every piece of content he produces has the power to make a difference in someone's life, and he's committed to using his words for good.

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