Searching for personal loans throws up a few terms and abbreviations that you may not be sure of; mostly, terms related to the rate of interest. There are usually two different rates for each option, and most often it’s the advertised rate that attracts you.The advertised rate is usually accompanied by a much higher Effective Interest Rate (EIR). But why are there two different rates? What does EIR mean? Which of the two affects your loan repayment the most?
It is the interest charged by the bank on the amount you borrow. It is also called the “Nominal Rate”, “Annual Percentage Rate (APR)” or “Applied Interest Rate (AIR)”, and has a straightforward calculation.
Effective Interest Rate is the overall cost of your loan. It shows the true cost of borrowing. Since you repay the loan over a series of instalments, you don’t have the money for the entire duration of your borrowing period. This increases the overall borrowing cost of your loan.
Banks also charge a processing fee on the total amount sanctioned for the loan, deduct it from the total, and give you the remaining amount.Banks also charge other fees such as administrative fees which are usually added to your interest payable. This adds to the cost of borrowing since you now have to pay back a higher amount. EIR factors all these parameters in to give you the actual loan cost.
Both the APR (or AIR) and EIR are important for different reasons.
Effective Interest Rate:
Loans with longer repayment periods have lower EIR and smaller monthly instalments. But this doesn’t mean that you should opt for longer tenures by default. Remember that you pay more interest in total over longer periods.
Your aim should be to repay the borrowed amount within the shortest duration, while ensuring that the monthly instalments are affordable. Choose a plan that offers the optimum rates and repayment duration for your monthly income.
Calculating EIR is a complicated process. The key points are:
Principal amount – S$10,000
Duration – 3 years
Annual flat interest rate – 7% (average rate of interest in Singapore for personal loans)
Processing Fee – 5%
|Average Principal (Total Principal ÷ 2)||S$5,000|
|Total Interest (Principal x Rate of interest x Duration) (10,000x7%x3)||S$2,100|
|Processing Fee (Principal x Rate) (10,000x5%)||S$500|
|EIR (Total Cost ÷ Average principal ÷ Duration) (2,600 ÷ 5000 ÷ 3)||17.33%|
The Code of Advertising Practice for Banks makes it mandatory for banks in Singapore to publish the EIR along with the advertised annual rate. This saves you the trouble of calculating it for every loan option. If the EIR is not displayed, ask your bank for it. In general, the effective rate is usually 1.8 to 2.5 times more than the annual or flat rates, after factoring in the processing and other fees. When comparing loan options, use a combination of both the annual rate as well as EIR to compare the differences. The annual rate tells you if the monthly instalment amount is feasible for you. The EIR helps you find out which loan is the cheaper debt option.