Cash woes? A personal loan to the rescue!

# Calculating Effective Interest Rate vs Annual Interest Rate

Taking a loan is a great way of getting the money you need to get you through tight financial situations. You apply for the loan, submit all the necessary paperwork, and get the money you need. It’s that simple, right? You then use the money for your specific need, enjoy its benefits, etc. until you have to repay what you borrowed. You open your monthly dues statement or you get the reminder from the bank, and you’re flabbergasted when you look at the amount that you are expected to pay. Something doesn’t add up. The monthly repayment amount does not coincide with what you had calculated. Have you ever been in a situation like that? Ever felt that you are being asked to pay a lot more than what you expected to? You feel that your bank is extorting money out of you when they initially promised to help you financially get through. Is your bank cheating you? No, it isn’t. Read on to find out more.

## Why the Difference?

There are, of course, many things you need to keep in mind when you apply for a loan, but the most important one to bear in mind are the interest rates. What many borrowers fail to understand is that most banks charge a higher rate of interest than what they advertise. They aren’t cheating you by doing so. This is where you need to know that the interest rate advertised by the bank i.e. the Applied Interest Rate (AIR) is not the same as the Effective Interest Rate (EIR) that applies on your loan.

So, why this difference? What is the need for two different rates of interest? Let’s take a look at the important differences between AIR and EIR. This should help you calculate your actual cost of taking the loan more accurately.

## Understanding Makes All the Difference

The fact that banks advertise one rate and seemingly charge another rate is not illegal. Understanding how these rates are calculated will give you an idea of why there are 2 different rates.

Let’s take an example to calculate simple interest on a loan. Say you want to borrow money from a friend, and he says he will charge you an interest of 10% p.a., with you paying him interest every month and the lump-sum amount in the final month. If you were to borrow S\$24,000 for a period of one year, at an interest rate of 10% p.a., in terms of simple calculation, this would mean that you would have to pay a total interest of S\$2,200 over 12 months. In effect, you would pay S\$200 every month as interest for 11 months, and S\$200 plus the principal amount of S\$24,000 in the 12th month. This is a simple and straightforward calculation, no hard calculations, and both you and your friend are satisfied.

Now let’s say you borrow the same amount from a bank, at the same rate of interest, and for a period of one year. Most banks expect you to pay them every month, but the instalment every month will include the interest amount as well as a portion of the principal amount. The following table explains the calculation:

Outstanding Principal (S\$) Monthly Instalment (S\$) Monthly Interest Rate* Monthly Interest Payable (S\$)** Total Monthly Instalment (S\$)
24000 2000 0.84% 201.60 2201.60
22000 2000 0.84% 184.80 2184.80
20000 2000 0.84% 168.00 2168.00
18000 2000 0.84% 151.20 2151.20
16000 2000 0.84% 134.40 2134.40
14000 2000 0.84% 117.60 2117.60
12000 2000 0.84% 100.80 2100.80
10000 2000 0.84% 84.00 2084.00
8000 2000 0.84% 67.20 2067.20
6000 2000 0.84% 50.40 2050.40
4000 2000 0.84% 33.60 2033.60
2000 2000 0.84% 16.80 2016.80
1310.40 25310.40

*The monthly interest rate is calculated as - 10% divided by 12 months, making it 0.84% per month.**The monthly interest amount can also be converted into equal monthly amounts of S\$109.20 by dividing the total interest of 1310.40 by 12 months, making each month’s payable amount S\$2,109.20. ^All amounts and rates mentioned are only for illustrative purposes. The actual calculations and figures may differ from one bank to another.

The above method of calculation can also be called the diminishing balance method (DBM), and under it, the total interest payable is S\$1,310.40, as opposed to S\$2,400 that you would pay to your friend.

## EIR and AIR Are Based on the Same Calculation

Now that we know how to calculate the monthly amounts under two different methods, would you be surprised if we told you that both AIR and EIR are based on the same calculation? In both the scenarios mentioned above, the flat rate of interest is 10%. The difference in the total interest payable is because of how the repayments are structured. When these two interest rates are shown as a percentage of the total principal amount you borrow, that’s where the difference between the effective rate of interest and advertised interest rate comes into the picture.

Under DBM, the total interest payable is S\$1,310.40, and the EIR calculated works out to 10.47% (without including other fees and charges such as processing that banks usually charge as a percentage of the loan amount they approve). However, when you calculate the total interest paid with the principal borrowed, the rate works out to 5.46%.

This 5.46% is the rate that banks usually advertise, hence earning it the name ‘advertised interest rate’. This does not reflect the true cost of borrowing since it does not include other charges like processing fees. EIR factors in all the fees and charges that apply on your loan and give you the true cost of what you will have to pay on the amount you borrow.

From these calculations, we see that there are 3 rates of interest that apply to this situation:

Effective interest rate – 10.47%

Advertised interest rate – 5.46%

Interest rate – 10%

### So What Should You Go By?

While AIR makes a loan amount seem a lot cheaper and easier to pay, we suggest that you always go by EIR. True, a lower percentage will result in you paying lesser in terms of interest, but since AIR does not include all the costs of borrowing, it would be unwise to take a loan based on a lower AIR. Since EIR shows you the full and true cost of what your loan will cost you, it will help you prepare better for your monthly repayments. It can get a little difficult to calculate EIR on your own for every loan option available in the country. Fortunately, you don’t have to calculate it on your own.

All the banks in Singapore usually give you the effective interest rate along with their AIR, simply because they are now required to do so by law. If they don’t, make sure that you ask them for it. Knowing what the EIR applicable on your loan is will help prevent unwanted surprises when you get your repayment reminder every month. If you do want to calculate EIR to verify what the bank is charging you, you can use the tool provided on Singapore’s Ministry of Law website.  reTH65gcmBgCJ7k
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