The advertised rate, also known as the nominal rate, is the total interest you will pay on the sum you borrowed. It is usually a low advertised rate compared to the effective interest rate, which is much higher.
It’s essential to understand the EIR before you get a personal loan. It helps you quantify and contrast the costs or returns of the same financial product in different lending institutions. It also helps you to know the conditions you can settle for and the ones you can do away with.
What Is EIR?
The effective interest rate is typically the true return on a saving account when compounding results are considered. In other terms, it shows the actual percentage rate of interest you owe a bank on your loan, credit card, and other debts.
It is also known as the effective rate, effective annual interest rate, or the Annual Equivalent Rate (AER). How it works is simple. It’s higher because it includes other costs like processing fee and administrative fee. The most distinguishing feature of it is that it considers compounding periods. The more they are, the higher the effective interest rate will be.
For example, you have gotten two loans, each containing a rate of 5%, in which the first one compounds annually while the other one compounds twice a year. Even if they both have a charged interest of 5%, you will pay a higher effective interest rate for the one that compounds twice a year.
Why are Effective Interest Rates Typically Higher than Advertised Rates?
As is always the outcome of a loan interest, you have to pay back a higher cost than your financial institution gave you. The amount varies with the effective interest rate in a manner that banks usually charge some extra fees, which, when incorporated into the interest of the loan you have applied, raises the amount of money you will pay back to your financial institution or bank.
Now that makes the effective interest rates higher than the advertised rates.
So the more you make frequent returns, the higher your effective interest rate will be. Let’s look at an example where processing fees or administrative fees are added to the loan. For instance, you get a S$10,000 loan with an interest rate of 10% and an administrative fee of 1%.
|Administrative fee (1%)
With that in mind, and then you include the administrative fee of 1%, you will have an effective interest rate of 11%, which is higher than the advertised rates. It is vital to note that administrative fee is just one component that affects the EIR. Other factors include:
- Tenure of the loan
- Frequency of installments
- Whether the installments are equal
The other factors stated above are also known as the repayment schedule.
How to Calculate EIR
Calculating an investment or interest on a loan can be challenging if you do not know how to do it. It will take a lot of work to get a clear view of the actual cost. However, you can follow these easy steps to calculate EIR successfully.
- Try to familiarize yourself with how the effective interest rate works.
- Find out the charged interest rate.
- Analyze the total number of compounding periods for your Loan
- Know the right formula for converting the highlighted interest rate to EIR.
- Then use the formula to calculate the effective interest rate.
- Also, know the formula to use in the case of continuously compounding interest.
- Finally, calculate the EIR in regards to continuously compounding interest.
What Is the Formula?
The EAR formula is as follows:
EAR= (1 + i/n)n _1
i – stated annual interest rate
n – number of compounding periods
In words is:
EIR = (1+ no of compounding periods/ nominal interest rate) no. of compounding periods-1
Most of the time, you will find a compounding period of one month. Additionally, in the above formula, the nominal interest rate does not necessarily mean the advertised interest rate. Instead, it indicates the internal rate of return on the loan’s balance.
You will also notice that this formula has not included additional costs like processing and administrative fees since those are usually already incorporated into the effective interest rate by lending institutions or banks.
When you want to do the calculations by yourself and find that challenging, you don’t have to stress yourself. You can access online calculators to help you with the estimate. You will be required to place the values like loan tenure, nominal interest rate, and frequency of installments, and it will calculate the EIR for you.
Is There a Tool You Can Use?
If you wish to do your own EIR calculations, the Ministry of Law provides an excel based EIR calculator that’s easy to use. All you need to do is key in the nominal interest rate, loan tenure, and frequency of installment values.
Is the Lowest EIR Always the Best Option?
In some scenarios, the loan with the lowest EIR is not always the best option. It might be a loan with the lowest cost, but you must put into account some factors before you decide to take that loan. Take a look.
1. The Amount of Interest You Will Pay for Getting a Loan
Generally, you will pay a lower EIR each month if you get a longer loan tenure. However, an extended loan duration will guarantee higher interest for the loan.
On the other hand, if you opt for a lower loan, it does not guarantee that you will repay a lower effective interest rate for the total amount of the loan awarded. It implies that the bank will consider other factors to determine the interest you will be charged.
2. If the Monthly Repayment Option Is Within Your Means
Always practice caution. Refrain from being manipulated to take a loan with a very low EIR when you opt for a shorter duration. It can be luring since you will settle your loan quickly, and you can apply for another one. However, you will end up straining to pay a huge monthly contribution which you could have avoided.
The best thing you can do is to take time and prepare yourself so that repaying your loan won’t be a struggle. Remember, if you delay payments frequently, some banks usually add more fees to the loan balance, which may lead you to repay more than you expected.
So the bottom line is not to be lured into getting a lower effective interest rate if you are not ready.
Other Important Things To Know About EIR
1. Is EIR Equal to IPR?
EIR is not equal to IPR. EIR is typically the true return on a saving account when compounding results are considered. In other terms, it shows the actual percentage rate of interest you owe a bank on your loan, credit card, and other debts.
On the other hand, intellectual property rights (IPR) are creations of the mind, artistic works, and inventions whereby the rights are given to creators over their designs.
Its primary purpose is to protect and control the distribution and development of new products like intangible assets.
2. How Can I Find Out What the EIR is?
It is crucial to understand that EIR is usually mandatory for you so that you can know the actual cost of borrowing. So you will always find licensed banks displaying EIR alongside the advertised rates.
Sometimes if you need help noticing EIR stated anywhere, look for advertised rates at face value. At the same time, you can inquire from the bank about EIR before you settle for anything.
Other than inquiring about EIR, you can also ask about the installment payment amount and proceed if you are delighted that you can pay all the monthly payments for the stated loan duration.
3. Is the Effective Interest Rate the Same as APR?
The Effective interest rate is not the same as APR. EIR considers compounding interest, while APR is mainly based on simple interest. Also, you use APR to evaluate auto loans and mortgages. On the other hand, EIR is commonly used to assess compounding loans like credit cards.
When compounding results are considered, the effective interest rate is the actual interest on a savings account. In other terms, it shows the real percentage rate of interest you owe a bank on your loan, credit card, and other debts. Remember to take time to analyze and understand the terms and conditions of the loan interest you are signing up for to avoid settling for less.
- The effective interest rate is the actual interest rate on your loan since it considers the outcome of compounding.
- More consistent compounding periods lead to higher effective interest rates.
- It would be best if you took the time to understand and compare loans and interest rates before you sign up for one.
- A saving account can have both effective annual interest rates and nominal interest rates.
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