Calculating Effective Interest Rate vs Applied Interest Rate

If you’re looking for a personal loan, you would have no doubt seen banks display two different interest rates: the Applied Interest Rate (AIR) and Effective Interest Rate (EIR). To showcase this, it might look something like “interest rates starting at 2% p.a. (EIR 6% p.a.).

Should you find yourself wondering why the bank is showing two different figures and which one you should actually pay attention to, you definitely aren’t alone.

Today, banks are doing a better job of explaining how the two interest rates differ. However, given the low amount of real estate on a product page and the need to actually promote the personal loan, a full explanation usually isn’t possible.

Essentially, the AIR is a flat rate whereas the EIR incorporates other costs. However, there are many other nuances at play. It’s crucial for you to understand both concepts so you can make a fully informed financial decision when taking up a loan from a bank.

Read on to find out more about AIR and EIR, and how you can calculate your loan’s effective interest rate should the information not be readily available on the bank’s website.

The Differences Between AIR and EIR

As mentioned above, the AIR is simply a flat rate. For every year of your loan tenure, the bank charges you a certain percentage on the principal amount as interest until you fully repay the loan.

For example, if you borrow S$10,000 at a 5% p.a. AIR for a year, you have to pay a total of S$500 in interest. This translates to a monthly interest of around S$41.67. Think of this as a base interest rate, before any extra fees and charges are tacked on.

Once you tack on these fees, the interest rate goes up and becomes the EIR. Essentially, the higher the EIR, the more interest you’ll have to pay.

Additionally, the EIR is higher than the AIR because the same interest rate that’s applied to the principal loan amount is also levied on the remaining balances and not lowered accordingly. To continue with the example from above, your remaining principal amount after six months of repayments would be S$5,000. However, you’ll still need to pay the original interest of S$41.67 that was applied to the S$10,000 you borrowed initially.

In short, the total amount (principal and interest) you repay the bank every month does not have any impact on reducing your interest whatsoever.

To further illustrate this, think about your credit card bills. Assume you have an outstanding balance of S$500 this month because you forgot to pay the bill in full. An interest fee will be charged on this S$500 in that case.

The following month, the same situation occurs but you now have an outstanding balance of S$100 instead of S$500. Interest will only be charged on the S$100 outstanding balance instead of the S$500 from the month before.

Although it’s indeed fair from a customer’s point of view to be charged in this way, do note that the interest rate for outstanding credit card balances is high. To be precise, it’s around 20% p.a.

Related: Best Air Miles Credit Cards in Singapore

How Do I Calculate My Loan’s Effective Interest Rate?

Calculating your personal loan’s effective interest rate can be a rather complicated process. You need to take into account the interest rate based on the reduced balance of your loan, which changes every single month. Then, you need to calculate what balance of your loan you’ll be carrying on average throughout its tenure.

Since you are paying back an equal amount of your principal sum borrowed every month, the average figure is actually just about half of the principal amount.

For example, if you took out a loan of S$5,000, then the average would be S$2,500.

Then, you can calculate the total interest you’ll be paying by using this formula: Principal Amount * Applied Interest Rate * Loan Tenure. The average interest rate for personal loans in Singapore would be approximately 7% p.a.

Therefore, a personal loan of S$5,000 repaid over three years would result in a total interest of S$1,050. And if there’s a processing fee of 3% on the principal amount (S$150), you’ll obtain the total cost of taking up the loan.

Finally, dividing the total cost (S$1,050 + S$150 = S$1,200) by your average balance (S$2,500) and the duration of the loan (three years) will result in the approximate effective interest rate of your loan. In this example, it’s about 16% p.a., roughly 2.3 times higher than the 7% average in Singapore.

If crunching the numbers on your own is too difficult, a rule of thumb to keep in mind would be that effective interest rates are generally 1.8 to 2.5 times higher than applied interest rates.  What’s more, Singapore’s the Institute for Financial Literacy has a handy EIR calculator you can download if you need a truly accurate EIR figure for your personal loan.

Related: A Basic Guide to Personal Loans

Conclusion

When you’re evaluating a personal loan in Singapore, it’s extremely important to consider both the AIR and EIR. While the EIR is indeed the true economic cost of the loan that takes into account its various fees, the AIR will also determine whether you can handle the monthly repayment you need to make for the next one to five years. You absolutely need to select a loan tenure that allows you to comfortably make your monthly repayments.

With that being said, the EIR is still a crucial figure to take note of. When comparing one loan against another, what will ultimately determine which option is “cheaper” would be its EIR. Make sure you carefully study and understand the total costs involved in taking out a personal loan.

Additionally, ensure your monthly finances and budget are able to manage the regular repayments which a personal loan will entail.

Your goal should be to find balanced personal loan, boasting a low AIR, low total cost, and manageable monthly instalments. The time and effort you spend to search for the best option possible will be worth it, especially if you’re planning to borrow a larger sum.

Read More:

• What Are The Top Uses, Pros and Cons of Personal Loans in Singapore?
• A Guide to Finding the Best Loans
• Benefits of Green Loans and How To Apply For Them
• Why Is A Credit Report Important And How Can It Impact You?
• How to Get the Best Credit Score to Apply for Loans in Singapore

Cover image source: Pexels