What is the actual interest rate on a personal loan?

When it comes to loans, it’s easy to be lured in by the ultra-low interest rates advertised. However, these figures don’t take into account a hidden cost: Real interest rate.

But what does the effective interest rate mean and how does it affect your payment?

To help you understand this, we will go into detail about what an EIR is and why it is important. Important factors to consider before applying for any type of loan.

Before you understand the other intricacies of the effective interest rate, you first have to know what the effective interest rate is.

The effective interest rate is the true cost of borrowing money, taking into account all fees and charges associated with the loan. The effective interest rate also takes into account compounding, which means that interest is calculated not only on the principal amount borrowed, but also on the interest accrued over a period of time.

The EIR on a loan more accurately reflects the total cost of borrowing than the advertised interest rate. This means that while the advertised interest rate may appear low, the EIR will more clearly reflect the actual cost of the loan in the long run.

So does this mean that banks are dishonest when publishing interest rates? Not necessarily. The published rate is just a starting point for calculating the actual interest rate.

Now that you know what the EIR is in the context of a loan, it’s time to learn why you should know more about it. We’ve rounded up some of the reasons why it’s crucial to consider the effective interest rate before taking out a loan:

As a loan applicant, you should assess whether you can easily repay the loan, whether it is a renovation loan, short-term loanOr a car loan. Knowing the actual interest rate means you can get a realistic idea of ​​how much the loan will cost you over time. This can help you decide if it’s worth taking out the loan.

What is an EIR in a loan? It is especially useful in the following situations: Compare different loan optionsWhile a loan may be advertised at a lower rate, the EIR may show that it actually costs more in the long run due to additional fees and compound interest. That’s why you should know how to calculate your effective interest rate.

For example, if Bank A and Bank B have the same ad personal loan interest rate, but because of the additional fees, Bank A’s effective interest rate is higher, so it may be more financially advantageous to choose Bank B.

Knowing the actual interest rate can also help you avoid any surprises or hidden costs. By knowing the true cost of borrowing, you can create a more accurate budget and avoid any unexpected financial stress in the future. Loan providers are also required by law to disclose the EIR to borrowers, so you have the right to know exactly what you’re getting before signing any loan agreement.

When you understand the true cost of borrowing through the EIR on your loan, you can factor loan repayments into your budget and adjust your spending habits accordingly. This can help you avoid defaulting on your loan or having trouble making ends meet while you’re making payments.

Additionally, the EIR can help you determine whether it makes financial sense to pay off your loan early. When you know what the EIR is on your loan, you can calculate how much interest you could save if you pay off your loan early.

Calculating the effective interest rate can be a little tricky, but luckily, all banks and financial institutions display this metric on all their loan products. However, if you’re wondering how to calculate the effective interest rate, here’s the formula:

Where:

R: annual interest rate

N: number of compounding periods

To give you a better idea of ​​what the effective interest rate is, here’s an example. Let’s say you take out a loan of S$1,000 with 12 monthly instalments of S$87.5 each. The annual interest rate on this loan is 5%. To calculate the effective interest rate, divide the APR by 12, which gives you 0.417%. Then, fill in the formula:

So what does this mean? Overall, the EIR is 5.2. Based on the effective interest rate implication, you will pay S$1,520 over the entire loan tenure.

Considering the above formula, the length of the loan has a big impact on the effective interest rate. The longer the loan term, the lower the effective interest rate. If you use the above example and change 12 months to 24 months, the effective interest rate will drop to 4.7%. However, this may also mean that you end up paying more in total interest over the life of the loan.

This is because, the longer the loan term, the lower your monthly payments will be, which makes the loan seem more affordable, but it also means you’ll be paying interest for a longer period of time.

Conversely, the shorter the loan term, the higher the monthly repayments will generally be, but the total interest costs will be lower, so the effective interest rate will be higher. Therefore, choosing the right loan term is a balance between managing your monthly budget and reducing your total borrowing costs.

Borrowers don’t have to worry about the concept of EIR in loans, but they should understand it. Taking out a loan is a big decision, and knowing the actual cost of borrowing money can save you from financial stress.

Don’t be lured by low interest rate ads without considering the actual interest rate and all associated fees and charges, and as always, be sure to evaluate your own financial situation and choose a loan with a manageable repayment plan that fits your needs. Also, don’t skip the process of how to calculate your actual interest rate. With the right knowledge, you can borrow responsibly.

Ready to apply for a personal loan? Get a tailored loan offer here.