How To Calculate Effective Interest Rate vs Annual Interest Rate

If you want to get a personal loan in Singapore, you’ve no doubt visited several banks’ websites by now. And so you’ve noticed that banks post two different rates: the annual flat interest rate and the effective interest rate.

Sometimes, just to hook you, they’ll advertise the loan’s annual rate, saying something like “quick fast cash as low as 3.88% p.a.” – that’s DBS’s slogan.

But underneath that slogan, there’s a parenthesis stating “EIR 7.56% p.a.”.

So – what are you actually paying in terms of interest to your bank? Are financial institutions trying to trick you? How do you calculate your effective interest rate, annual interest rate and how much do you have to pay?

Here are a few examples to help you.

Effective Interest Rate & Annual Interest Rate – Why Should You Care?

Aren’t they both interest rates? What is the difference?

Well, one reason why you should definitely care about these two concepts is that they affect how much you’re reimbursing to banks. Besides, you won’t find many clarifications on banks’ websites; some don’t even show you how they calculate these types of interest.

So, if you don’t understand how these interest rates work, you’re more likely to select the wrong loan.

But we’ll tell you this:

EIR – although the more expensive of the two – is also the more important.

What’s The Difference Between The Annual Interest Rate & Effective Interest Rate?

We’ll start with the most accessible concept of the two: the annual interest rate.

The good news is that the annual interest rate is flat, so it’s easy to calculate. Let’s say that you’ve borrowed $12,000 from a bank at 5% interest for one year:

• 5% out of $12,000 is $600 – that’s the interest you’ll have to pay for the whole year.
• Divide that by 12, and you get the interest/month: $50.

Some sources advise beginners to disregard the annual interest rate when they’re evaluating offers from different banks. However, that approach isn’t correct.

Here’s what happens: Your annual interest rates show you the amount you have to reimburse each month. It’s essential to figure this sum out first because you’ll have to fork it out constantly until your loan term is up.

This loan repayment amount should not affect your monthly savings or monthly goals too much. As we progress in life, we may need to purchase a car to bring our family around or upgrade our property. We need to know how we can set financial goals to purchase a car or property in Singapore.

Here’s how you calculate a loan of $12,000.

That’s how the annual interest rate table looks for your loan of $12,000.

Now you probably have one question: How do you find out the monthly installments?

After all, we hadn’t disclosed them when we first gave you this example, and banks don’t do that either. The good news is that it’s easy to calculate them yourself:

All you have to do is add the total interest rate we said was $600 to the $12,000 loan you’re taking. That’s $12,600. Divide this amount by 12, and you get the $1,050 monthly installment you’re looking at for the entire year.

Now let’s discuss the effective interest rate.

EIR shows customers the actual economic price of a specific personal loan. But we agree that understanding how effective interest works is challenging, especially since banks in Singapore won’t explain this term thoroughly.

You can expect to see some banks stating that EIR varies depending on your AIR and processing fee. For instance, lower annual interest rates will lead to lower effective interest rates, and they’re going to give you some percentages to see some distinct EIR values.

But no one actually explains how you calculate these percentages from the annual interest rate.

Let’s explain: We’ll start with that processing fee. If you take a personal loan in Singapore, you can expect a 2-4% processing fee that the bank will withhold from your loan when they transfer the amount.

Keep in mind that for banks, that processing fee can’t amount to more than $200. You can expect a maximum 10% admin charge for moneylenders, but of course, only after they transfer you the money.

Obviously, that processing fee is a cost you’ll have to pay, which is why banks include it in their practical interest rate calculations.

But why is the effective interest rate so much larger than your annual interest rate? That $200 extra don’t account for much more than $8/ month.

Here’s the thing:

When you get a loan in Singapore, you won’t use the entire sum for the whole loan term. Look at your monthly installment table again. Each such installment includes two sums:

• Interest
• Payment towards your principal amount

Consequently, even though you’re actively paying installments monthly, those sums won’t decrease the payments you’re making towards your interest.

Let’s compare that with credit cards:

Credit cards work differently than bank loans in Singapore and, in fact, all over the world. That’s why so many people are attracted to using them despite their massive snowballing interest rates.

That little catch is called no interest.

Yes, if you manage to pay your outstanding balance in full in one month after withdrawing that money, you won’t pay any interest for it. Obviously, most times, people are hypnotized by this promise, so they take out more money than they can afford to repay. Over time, your credit card debt will snowball as most users choose to repay the minimum amount only. In fact, a fast cash loan is of lower interest than a credit card.

But that’s another story. Also, if you’re wondering are pawn shops in Singapore better, read our review here.

For now, let’s discuss the issue you’re here for: how to calculate the effective interest rate for a loan you’re taking.

How Do You Calculate The Effective Interest Rate?

When we discussed the annual interest rate calculation process, we said it was simple. Well, this one’s complicated because the EIR depends on your outstanding balance, and that changes each month as you work through your installments.

So, here are the steps:

1. Find out the loan balance that you have on average throughout your loan term.

Remember that you’re putting equal sums towards the principal amount each month. Like in the table above, you were repaying $1,000/month towards your balance.

That means:

Your principal amount’s average is around half that amount. So for a $30,000 loan, that average would be $15,000.

2. Calculate the total interest you’ll pay for your loan

You can find out the total interest you’ll pay by multiplying these three factors:

• Your original loan amount – aka the principal sum
• The annual flat interest rate
• Your loan term or tenure – aka the total number of years you’re taking the loan for

Now, let’s say you’re getting a $30,000 loan at a 5% annual interest rate for three years.

The total interest you’ll pay is $30,000 x 5% x 3 = $4,500.

3. Calculate the total loan cost

The total loan cost means adding all the other fees applicable. Here are the steps:

• Calculate your 3% processing fee. That means 3% out of $30,000 = $900.
• Add that $900 to your total interest. That’s $5,400.
• The total loan cost is $30,000 + $5,400 = $35,400.

4. Calculate the effective interest rate

The effective interest rate represents the actual interest rate that you’ll have to repay based on your loan amount and tenure.

You can find out your EIR = total loan fees/ (loan average x loan tenure)

In this case, your EIR = $5,400/ ($15,000 x 3) = 0.12

Now compare that 12% effective interest rate to the advertised 5% annual interest rate – it’s 2.4 times as much. And usually, that’s the case with all effective interest rates: they’re 1.8-2.5 times larger than the annual interest rates.

What’s The Difference Between Licensed Moneylenders And Banks?

Did you know that licensed moneylenders aren’t allowed to ask for more than 4%/month in interest. In fact, the lowest interest rate you can get is at 1%/month. It may sound more expensive compared to banks, but with all things in this universe, there are pros and cons.

Here’s the thing, though: Some licensed moneylenders won’t ask for that much interest, especially if your credit score is good.

Secondly, what if you don’t qualify for a bank loan? Legal lenders in Singapore will still help you so that basically means you’ve more chances of getting a loan when you desperately need one. It is a legal alternative, especially for those who need money urgently.

And, even if those interest rates are higher, your licensed moneylender will know how to balance your monthly installments. Thus, if your monthly installments are affordable, you won’t care much about your interest.

There are also no early repayment fees should you be able to repay your loan in full before the stipulated deadline.

In Conclusion

If you want to obtain a personal loan in Singapore, you must be very careful when comparing different options. So, consider both the annual interest rate and the effective interest rate:

• The EIR shows you how costly your loan is because it considers all the other associated costs, including the processing fees.
• Your annual interest rate tells you your monthly installment – and that ultimately shows whether or not you can afford that loan.

Here’s what that means:

If you want to determine the cheapest loan, use the EIR. Once you’ve decided on a loan, double-check your monthly budget and see if that loan’s installment is feasible.

Your ultimate goal is to get the best personal loan, which means one with low interest, low installments, and low total cost.

The good news:

You can get it here, right now.

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