Effective Interest Rate vs Annual Interest Rate: What’s the Difference?

Effective Interest Rate vs Annual Interest Rate: What’s the Difference?

If you’re curious about interest rates, moneylenders in Singapore usually impose effective interest rate (EIR) and annual interest rate for personal loans. You should take note of these two when comparing loan offers from banks and other lending institutions. While the EIR is a bit more important than the annual rate, the latter is still a factor for the total cost of repaying your debt.

Not all lenders follow a simple calculation of these two rates, especially if you plan to borrow money from licensed money lenders in Singapore. There are around 160 licensed lending companies in the country, according to the Ministry of Law. Hence, it can be difficult to compare loan products if you are unaware of the difference between the EIR and annual rate.

Calculating the Annual Rate Is Simpler

According to ValueChampion, the annual rate refers to the lender’s charge on the money that you borrow per year until you fully pay the loan. Let’s say that you borrowed $5,000 with a flat rate of 6% for one year. The interest will amount to $30 per month. The annual flat rate will determine the actual amount that you need to repay every month.

Based on the example above, you would pay $450 per month comprising $33 in interest and $417 as the monthly principal payment. Depending on the terms and conditions of the loan agreement, you may pay a different amount if the contract says otherwise. Check the lender’s sample computation of the annual rate for one year to estimate how much you need to pay each month. The annual flat rate also provides you with an idea of whether or not you can afford to repay the loan in just one year, which means you may need to consider a longer repayment period. This will, of course, require a different computation if you prefer to pay off your debt for more than 12 months.

How You Can Calculate the EIR

The EIR is more complicated. You should consider it to be the true economic cost of borrowing money from a bank or money lender. Some banks may advertise the EIR as the result of taking the processing fee into account. However, you should do your due diligence by knowing the fee’s impact on the loan’s EIR. Most personal loans in Singapore usually have a processing fee rate between 2% and 4%, which can cost up to $200.

You don’t have to pay this amount. Instead, the lender will deduct it upon loan disbursement. The EIR is normally higher than the annual flat rate based on the concept that you don’t really use the entire amount during the loan tenure. If you borrowed $20,000, for example, the actual loan proceeds will be smaller because the lender will deduct any fees and charges from the loan proceeds.

At this point, you may be scratching your head if it’s worth the time to consider the EIR. For those who are keen on making a thorough comparison, consider the interest rate based on the reduced balance of the loan after every monthly payment. Since you pay the principal and interest every month, your outstanding balance obviously changes over the course of the loan tenure. Follow the steps below to estimate the EIR:

  1. Multiply the principal amount to the flat interest rate, get the product and multiply it again to the loan tenor. If you borrowed $5,000 with an annual flat rate of 7% over three years, the estimated total interest will be around $1,050 for three years.
  2. Multiply the principal amount to the flat interest rate, get the product and multiply it again to the loan tenor. If you borrowed $5,000 with an annual flat rate of 7% over three years, the estimated total interest will be around $1,050 for three years.
  3. Add the total interest to the processing fee. Let’s say that the lender charges 3%, which is $150. This is the total cost of the loan.
  4. Divide the total cost to the average balance of your loan. The average balance is usually around half of the principal. In this case, it is $2,500 throughout the loan tenor.
  5. Divide the quotient to the loan duration, which is three years. The estimated EIR for a $5,000 loan will be around 16%. This is 2.3 times higher than the annual rate of 7% over 3 years.

In summary, the total cost of a $5,000 loan is $1,200 comprising the interest rate payment of $1,050 and processing fee of $150. This is a thorough calculation, but there are simpler ways to estimate the EIR. You can use the Ministry of Law’s EIR calculator, or you can just estimate the EIR by multiplying the flat rate by 1.8 to 2.5. 

The Difference in Rates Between Banks and Money Lenders

The Singaporean government imposed a cap on the interest rates that licensed money lenders can charge to customers. Licensed money lenders shouldn’t charge more than 4% on monthly interest rates, which are up to five times higher than rates charged by banks. However, not all lending companies charge 4% on their rates for personal loans. Your credit score and payment history will be two important factors for the actual rate.

Most people think that lenders charge too expensive fees for their loan products. This might be true if you have little to no credit history, as well as having a bad credit score and a record of loan default. For those with a high credit score yet still find it hard to borrow money from banks, then licensed moneylenders are a good alternative.

Take note that some lenders also observe a cap on the loanable amount. If you earn below $20,000 per year, you may only borrow up to $1,500 depending on the money lender. On the other hand, banks can lend up to six times your monthly salary (up to $200,000) provided that you have a higher annual income. 

Conclusion

If you prefer to ask for advice on interest rates from an expert, visit Loan Advisor’s website for the latest resources on everything about consumer loans and financial management. Use our loan comparison and analysis tools for finding the best licensed money lender in Singapore. Call us today and know more about lenders with the lowest EIR and annual interest rates.

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