When advertising loans, banks are fond of displaying two different interest rates: the annual interest rate and the Effective Interest Rates (EIR) with the latter typically higher. It doesn’t help that banks don’t really try to explain why there are different rates for these two terms and how does one properly calculate the annual interest rate and EIR. It is helpful to understand and differentiate between these two concepts in order to make well informed financial decisions.
With so much being said, what exactly is the difference between these two?
The broadcasted interest rate (nominal AR), is a flat annualised rate and doesn’t include compounding as per the Singapore Money lenders act.
This parameter is usually used as the standard rate not just in the country but also in numerous other countries and it’s simple to calculate. The interest can be computed by multiplying the quoted yearly interest rate (say 8 percent p.a.) times the principal.
For example, if one borrows $10,000 at an Annual Percentage Rate (APR) of 8% p.a. for 1 year, he/she will be charged $800 in interest. If the period were to extend to 3 years, he/she will pay $800 x 3 years = $2,400 in interest.
The EIR works along a compounding effect and is dependent on the frequency of amortized installments over a period of one-year meaning that it better reflects the true cost of credit over one-year. Banks also charge assorted fees on their loans, such as administrative and processing fees, which they add to the cumulative interest charged on loans. This no doubt increases the total amount people have to repay as the interest. Due to these extra captured costs and the mentioned compounding, EIR is always greater than the nominal APR for any debt provided compounding occurs more than once a year. The MAS (monetary authority of Singapore) requires that that lenders assess and disclose the EIR amounts in the loan agreement.
How is the EIR Interest Charge Calculated?
Calculating EIR can be confusing since it not only includes the compounding factor but also other loan charges plus any penalties that could arise in the course of repayments. EIR also recognises that borrowers are paying back a fraction of the principal amount borrowed each month coupled with the interest rate assessed on the opening sum. Each month, the computation of the interest due on the facility is based on the principal amount remaining after deducting total payments made that far from the borrowed principal.
For example, if Cheng takes a personal loan of $10,000, and has already repaid $4,000, only the pending $6,000 will be charged when determining interest. Then, late interest should only be imposed on the amount that has been repaid late. The financial institution cannot charge it on outstanding amounts that are not yet due. To illustrate, if Chang takes an advance of $10,000, and defaults on the first payment of $2,000, the banker can only penalize the delayed interest on $2,000 and not on the outstanding $8,000 seeing that it’s not yet due.
Assuming one takes out a personal loan of $10,000 for 3 years at 8% with a processing fee of 3%, the values would be as shown:
First, one must calculate the average balance of the loan that the borrower will be carrying throughout the term. This should be half of the original principal so in this case it will be $5,000 (50% of $10,000). The interest will be on the reduced balance which means it changes every month.
Here is the formula to get the actual interest:
Principal x Quoted Interest Rate x Loan Tenure= $10000 x 8% x 3 = $2400
Before computing the rest, the 3% processing fee should be added: 3% x $10000 = $300
So, total loan cost = $2400 + $300 = $2700.
Then divide this cumulative loan charge by the average balance plus the duration to get the EIR.
Hence, the EIR = $2700 / ($5000 x 3) = 18%.
This shows that the effective interest is more than double the annual nominal rate (8%). The EIR is usually 1.8 x to 2.5x more than the nominal interest rates- after bank fees. Individuals can also determine their effective rates using this spreadsheet or other online tools.
The EIR And Loan Tenure
Loans with lengthy tenures have lower EIRs and subsequently smaller monthly installments. This shouldn’t sway people towards picking loans with longer tenures as they may not be necessarily good: interest paid over longer periods sums up to colossal amounts.
The goal should, therefore, be to clear the borrowed figures within the shortest time possible while maintaining the monthly installments at a reasonable level. Clients should, thus, choose a plan offering optimum rates and repayment durations that won’t stretch one’s monthly income.
Should One Pick The Least EIR?
Borrowers should pay close attention to this interest when taking loans as it gives the best estimate of the real cost of borrowing. However, going for the lowest EIR automatically may not be wise as the EIR may change depending on how the credit product is structured and not to forget the loan amount.
Can The Bank Fail To Disclose The EIR?
As earlier mentioned, all financial institutions must disclose everything, not just the EIR, to their clients. Clients are also free to seek further clarification from their lending companies when in doubt about the computations or any of the provided analysis before appending signatures on the dotted line. When comparing loan offers, it is wise to use a mix of both the EIR as well as the annual rate. The annual rate tells if the suggested monthly installment figure is feasible or not while the EIR helps Singaporeans to evaluate the myriad loan options for cheaper debt.
Whenever evaluating any personal loans in Singapore, it’s crucial for a consumer to consider both the annual flat rate and the EIR. The EIR shows the actual economic cost of a loan by capturing every other detail including the loan accounting fees while the annual flat rate gives one an idea on whether one can manage the monthly amortisations. Calculating the EIR is cumbersome but there are online calculators and tools that an individual can use to predict their EIRs. Besides, lending companies are required by the Singaporean law to publish the EIR value on the loan documentation, meaning the information can also be obtained from the bank.
One should not just go for loans with seemingly lower EIRs. Rather, individuals should concentrate on the structure of the loan and all other involved costs. Ensure that you have done the necessary homework and fully understand the costs involved in taking up a loan, and make certain that you are able to afford your monthly repayments with your income.
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