What Is Effective Interest Rate In Personal Loan?

When it comes to loans, it’s easy to be overwhelmed and tempted by super low advertised interest rates. However, there’s a hidden cost that these numbers do not account for: the effective interest rate.

 To help you navigate this, we’ll break down everything you need to know about EIR and why it’s an important factor to consider before taking out any type of loan.

• What is the Effective Interest Rate?
• Is EIR the same as the Advertised Interest Rate?
• Why Is It Important to Consider EIR?
  • Loan assessment
  • Comparison
  • Transparency
  • Budgeting
• How to Calculate Effective Interest Rate

Also called EIR, the effective interest rate in Singapore is the true cost of borrowing, taking into account all the different fees and charges associated with a loan. The EIR also takes into consideration compounding, which means that the interest is calculated not only on the principal amount borrowed but also on the accrued interest over time.

Compared to the advertised interest rate, the EIR gives a more accurate representation of the total cost of borrowing. This means that while the advertised interest rate may seem enticingly low, the EIR will give a clearer picture of what the loan will actually cost you in the long run.

So, does this mean banks are being dishonest with their advertised interest rates? Not necessarily. The advertised interest rate is simply a starting point for calculating the EIR.

We’ve rounded up some reasons why considering the EIR is crucial before taking out any loan:

As a loan applicant, you should assess whether you’ll be able to comfortably repay the loan. The EIR gives you a realistic idea of what the loan will cost you over time. This can help you make a decision about whether the loan is worth taking out or not.

The EIR can be especially useful when comparing different loan options. While one loan may have a lower advertised interest rate, the EIR may reveal that it actually costs more in the long run due to additional fees and compounding interest.

For example, if Bank A and Bank B have the same advertised interest rates, but Bank A has a higher EIR due to additional fees, it may be more financially beneficial to choose Bank B instead.

Understanding the EIR can also help you avoid any surprises or hidden costs. By knowing the true cost of borrowing, you can make a more accurate budget and avoid any unexpected financial strain in the future. The law also requires loan providers to disclose the EIR to borrowers, so you have the right to know exactly what you’re getting into before signing any loan agreement.

When you know the true cost of borrowing, you can factor in the loan repayment into your budget and adjust your spending habits accordingly. This can help you avoid defaulting on the loan or struggling to make ends meet while paying it off.

In addition, the EIR can also help you determine whether paying off the loan early would be financially beneficial or not. When you know the EIR, you can calculate how much interest you’ll save if you pay it off sooner.

Calculating the EIR can be a bit tricky, but thankfully, all banks and financial institutions display this metric for all their loan products. However, if you want to calculate it yourself, here’s the formula:

Where:

R:  annual interest rate

N: number of compound periods

To give you a better picture, here’s an example. Imagine you take out a S$1,000 loan with 12 monthly instalments of S$87.5 each. The annual interest of this loan is 5%. To calculate the effective interest rate, divide the APR by 12 to get 0.417%. Then, fill in the formula:

So what does this mean? In total, the EIR is 5.2% so you will be paying S$1520 for your entire loan term duration. 

Considering the formula above, the loan term greatly affects the EIR. A longer loan term tends to result in a lower EIR. If you use the example above and switch out 12 months to 24 months, the EIR will drop to 4.7%. However, it may also mean you end up paying more in total interest over the life of the loan.

This is because, with longer terms, your monthly payments are lower, which can make the loan seem more affordable, but it also means you’re paying interest over a longer period.

Conversely, shorter loan terms typically have higher monthly payments but lower overall interest costs, resulting in a higher EIR. Therefore, choosing the right loan term is a balance between managing your monthly budget and minimising the total cost of borrowing.

The concept of EIR isn’t something borrowers should fear, but rather educate themselves on. Taking out a loan is a big decision, and understanding the real cost of borrowing can save you from financial strain.

Don’t be lured in by low advertised interest rates without considering the EIR and all associated fees and charges, and as always, make sure to assess your own financial situation and choose a loan with a manageable repayment plan that suits your needs. With the right knowledge, you can borrow responsibly.

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