Do you know the difference between effective interest rates and simple interest rates?
If you are planning to apply for a personal loan, then you’ll likely see these two terms being used by banks and licensed moneylenders in Singapore. These financial institutions often use lower effective interest rates or lower simple interest rates in their advertisements.
It can be quite confusing as the only difference is between the words “effective” and “simple”. Most of the time, definitions of these two are not explained. Most people do not know the difference between effective interest rates and simple interest rates.
In fact, a lot of borrowers sign loan contracts without knowing what they’re agreeing to. How do we calculate effective interest rate? That’s why we created this guide – to help you understand the difference and make more informed decisions about your borrowing. It is important to know what loan you’re taking. It could save you a lot of money in the long run!
What Is Simple Interest Rate?
The simple interest rate is the annual interest rate charged on a loan. The key word here is “simple,” which means that the interest is not compounded or added to the loan’s principal.
Here’s what that means in ordinary English: With a simple interest loan, you only pay interest on the original amount you borrowed.
This is in contrast to a compound interest loan, where you pay interest not only on the original amount borrowed but also on any interest that has accrued in previous periods.
The simple interest is typically lower than the compound interest rate, making it a more attractive option for borrowers. However, it’s important to remember that you will ultimately pay more interest over the life of a simple interest loan since the principal never decreases.
For this reason, shopping around and comparing both kinds of loans is essential before making a decision.
Simple Interest Rate Formula
As any financial advisor will tell you, the simple interest rate formula is critical for understanding how loans work:
I=PRT, or Interest = Principal x Rate x Time.
In other words, the amount of interest you will pay on a loan is determined by the size of the loan (principal), the interest rate, and the length of time you borrow the money (time).
Of course, things are rarely that simple in reality.
Most loans also have compound interest, which means that interest is calculated not only on the principal but also on any accumulated interest from previous periods. In addition, many loans have variable interest rates, meaning the formula needs to be recalculated every time the rate changes. Nonetheless, understanding the basic principles of your loan interest rate can help you make more informed decisions.
How To Calculate Simple Interest?
When you take out a loan, the amount you borrowed is called the “principal”. It can also be referred to as the principal loan amount.
The loan interest rate is the fee you pay for borrowing the money, calculated as a percentage of the principal.
Here’s how you calculate the interest rate:
If you borrow $100 and the interest rate is 10%, you’ll owe $110 at the end of the loan period.
Simple interest is the most basic type of interest calculation, and it’s easy to figure out. You multiply the principal by the interest rate and then multiply that by the number of days in the loan period.
So, if you have a $10,000 loan with a 3% monthly interest rate and a 6-month loan period, your calculation would look like this: $10,000 x 0.03 x 6 = $1,800 in interest charges
As you can see, simple interest can add up quickly. That’s why it’s important to shop around for loans with the best interest rates before you decide to borrow. Before committing to a loan contract, read the customer reviews and compare their loan packages.
What Is The Effective Interest Rate?
The effective interest rate is the actual rate of interest that a borrower pays on a loan after taking into account any fees or charges. In other words, it’s the actual cost of borrowing money.
The effective interest rate is not the same as the advertised interest rate. The advertised rate is usually lower than the actual rate because it doesn’t take into account any fees or charges.
Why Is The Effective Interest Rate Crucial?
Why do you need to know about the effective interest rate? The effective interest rate is the true cost of borrowing money, and it’s crucial because it allows you to compare different loans.
Let’s say you’re considering taking out a loan for $10,000.
The first lender quoted an interest rate of 5%, while the second quoted an interest rate of 6%. Based on the quoted rates, you might think the first loan is better because it has a lower interest rate.
However, the effective interest rate takes into account the fact that the first loan has a longer term than the second loan. When you compare the two loans based on their effective interest rates, you’ll see that the second loan has a lower borrowing cost.
As a result, the effective interest rate is a much more accurate way to compare loans and ensure you’re getting the best deal.
Effective Interest Rate Formula
The effective interest rate is the actual annual cost of borrowing, expressed as a percentage. To calculate it, you take the stated or listed interest rate and divide it by the number of compounding periods per year.
Effective annual interest rate = (1 + (nominal rate / number of compounding periods)) ^ (number of compounding periods) – 1.
For example, if you’re considering a loan that has a stated interest rate of 6% and compounds monthly, your effective interest rate would be 6.17% ((1+0.006)^12-1)).
That’s why we keep saying that effective interest is the “true” cost of borrowing money.
And yes, we know that’s not very exciting.
But trust us, it’s important to understand! Now that you know how to calculate the effective interest rate, you can use it to compare different loans and choose the right one.
How Will Interest Rates Affect My Loan?
The answer to this question depends on what type of loan you have.
If you have a fixed-rate loan, your interest rate will not change for the life of the loan, no matter what happens with market rates. So, if interest rates go up, you’ll be happy you have a fixed-rate loan.
However, if interest rates go down, you may be sorry you didn’t choose a variable-rate loan. That option would have decreased your loan interest rate along with the market rates.
Of course, there’s always the risk that interest rates could increase again.
That’s why it’s essential to weigh all the factors before deciding which type of loan is right for you. In any case, it’s always a good idea to keep an eye on interest rates so you can be prepared for whatever changes may come.