Making sense of effective interest rates

By YuanDuan - 1 August 2019
3 mins read

Any respectable Singaporean obsesses over finding the best deals, hunting for the lowest prices to stretch our dollar. So, it should be no different when we consider taking a loan. Perhaps especially so in loans, as there is no real way for lenders to differentiate their offering through service or manufacturing quality – after all – money is money.

 

So we should always borrow at the lowest interest rates to get the best value.

 

But if you have been loan-hunting, you will have come across two interest rates on the same loan. One rate is called the effective interest rate, or EIR, and this rate is almost always higher than the advertised rates of the loan.

 

So, what’s this EIR?

 

Well, in Singapore, lenders are legally required to display loan EIRs, providing a transparent way for borrowers to evaluate the cost of borrowing.

 

Great, but how do we use it? Do we simply sign up for the loan that offers the lowest EIR?

 

As with most things in life, yes and no. Let’s make sense of EIR.

 

Why are there two interest rates?

Advertised, or nominal rates, are the interest rates you see on ads on loans, usually screaming “LOWEST RATES IN TOWN”. Here’s an example of nominal rates in action.

 

 

In this example, you pay $200 in interest – 2% of $10,000 – nothing surprising here.

 

But EIR takes other factors into consideration to provide a fuller picture of a loan’s value.

 

EIR takes into account processing fees

EIR also considers admin and processing fees paid upon signing the loan.

 

If we use the same $10,000 example, but now, toss in a fee of $500. This means the $10,000 loan is now actually only “worth” $9,500.

 

 

Simply put, because of the fees, the loaned amount is effectively lessened, reducing the true value of the loan. So that’s why the EIR usually shoots over the nominal rate.

 

EIR also changes according to the repayment period

Lastly, EIR takes into account how interest is charged by the banks. For example, some loans might have their interest rates applied and compounded every quarter, but in advertising, 4 quarter’s rates are totalled to show a ‘standardised’ annual interest rate.

 

Here’s an example
Loan A – 2% applied at the end of the year.
Loan B – An advertised 2% annual interest rate, but compounding at 0.5% every quarter.

 

observe how loan b’s interest rates rolls over each quarter, attracting more interest

 

So EIR can reveal extra percentage points hidden behind advertised annual interest rates with different interest compounding schedules. It a small difference, but it’s there.

 

Frequency of installments

How often a loan schedules installments also affects EIR.

 

Again, let’s compare between two 1 year, $10,000 loans with a nominal interest rate of 2%. But this time the difference is in their repayment schedules.

 

  • Loan A
    • $850 monthly installments
    • Total of $10,200 repaid
    • EIR 3.73%

 

  • Loan B
    • $2,550 quarterly installments
    • Also a total of $10,200 repaid
    • EIR 3.23%

 

This is the most confusing part about EIR, it’s the same repayment amount of $10,200 a year later, but Loan A has the higher EIR. What gives?

 

This is because EIR takes into account how quickly you have to repay a loan. Simply put, the quicker you have to repay, the less cash on hand you have to use.

 

To illustrate this, imagine walking out of a bank with a fat loan, but having to pay the first installment back within two days. That sucks.

 

Now contrast this with another loan where the first installment is paid a month later. Obviously, this is preferable.

 

While this example is extreme, but it illustrates how EIR also takes into account different loan repayment schedules to evaluate loans.

 

However, in this case, even with the lower EIR, the borrower requires the discipline to have the money set aside for the larger (but more spaced out) installments when payback time comes around.

 

When using EIR is not a good idea

So far, it’s plain to see that taking the loan with the lowest EIR can be a great reference point in selecting the cheapest loan.

 

But be careful when selecting a loan purely on the basis EIR. In the bigger picture, longer tenure loans will always have more interest charged – even with lower annual EIRs – here is a simple example.

 

notice that even with a lower EIR, you still pay more for longer loans

 

So as you can see, while useful, EIR can’t be the end-all in the loan selection process.

 

But if you read up to here, you might have gotten an inkling on how to use EIR effectively: Comparing loans with similar tenures to find the best value, and in this case, it’s certain that the lower the EIR the better.

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