Compare Effective Interest Rates VS Simple Interest Rates: Cost Of Borrowing
Planning to take a loan with a bank or a licensed moneylender?
Regardless of your choice of lender, it is important that you understand what are effective interest rates and how to calculate effective interest rates. While banks and financial institutions often advertise low interest rates, how much exactly is the cost of borrowing? What is the monthly rate and how do you calculate the EIR on a loan?
Always be cautious when you are shopping around for a personal loan. Be a smarter consumer by knowing what you are getting yourself into. You don’t want to end up being shocked by the monthly repayments and find difficulties in repaying your loan. Though EIR is a little more important than a flat interest rate, it is still better to know what you are being charged and what you are paying for.
Read this guide in order to make a fully informed financial decision for your loan.
What Is Simple Interest Rate?
A simple interest rate is the most basic way of calculating the amount you will pay for borrowing a loan.
It’s also known as nominal or flat rate and is applied to the principal amount borrowed. The interest amount remains constant every period as it does not account for compounding.
Compounding means charging interest periodically on the loan balance after paying the previous installment. Hence, if you fail to pay an installment, the interest amount adds to the principal balance, and then you will pay more interest in the next period as the balance will have increased.
A good example of a financial product that uses compounding interest rate would be credit cards. Usually, credit cards will compound interest daily. That might be a little troublesome for credit card users who are unable to make monthly payments. To reduce the cost of borrowing from credit cards, you can try to transfer the bill to personal loans that have fixed monthly repayments.
Simple Interest Rate Formula
The formula for a simple interest rate is straightforward, as it is only applied to the principal amount of the loan. This loan interest rate does take into account the effect of payments/ installments made by the borrower, which reduces the amount owed every period in a payment schedule.
Therefore, the simple interest formula is: i = P(rt)
Where; P is the Principal Loan Amount
t is the Number of Time Periods.
Note: r and t are in the same units of time (e.g. month or year).
How To Calculate Simple Interest?
Here is an example on how to calculate the interest rate for your loan.
For instance, if you borrow $100,000 from your bank, and you are to repay in ten (12) months, and the bank charges a simple interest rate of 1 per cent per month, you will calculate the interest amount payable using the formula as follows;
i = P(rt)
At the end of the agreed repayment period (12 months) you will have paid $12,000 as interest amount. Basically, your simple interest per month is constant at $1,000 irrespective of the reducing loan balance as illustrated below;
|Month||Principal $||Interest Payment Calculation||Interest Amount $||Principal Payment||Installment (Interest + Principal)||Balance|
|1||100,000||1% of 100,000||1,000||10,000||11,000||90,000|
|2||90,000||1% of 100,000||1,000||10,000||11,000||80,000|
Notes: All figures are in SGD.
What Is The Effective Interest Rate?
The effective interest rate (EIR) is that which is adjusted to consider the payments made over a given period and also takes into account such fees as processing fees and bonuses. Therefore, unlike the simple interest rate, EIR is not applied on the principal amount but on the periodic balance after making payments.
Why Is The Effective Interest Rate Crucial?
When you calculate the interest rate using the EIR, you will realise that you are paying the actual interest for the amount you owe the bank.
You are not obligated or burdened to pay interest on the amount you have already paid back to the lender.
You will also realise there is an incentive for making your repayment period shorter by paying larger installments. The total interest will be lesser, making the loan cheaper.
If you can get more money to make more frequent payments to the lender, the better still, as the interest calculations for the next period will be less. Hence, the effective interest rate shows the true cost of a loan. It also helps you make an annual interest comparison between loans with different compounding periods.
Effective Interest Rate Formula
When you take a given loan amount and based on EIR per annum, your lender will calculate the monthly loan repayment amount (installment), taking compounding into account. It’s from this installment that one portion goes to repay the principal amount, and the other goes into interest payment.
For instance, if you borrow the same amount of $100,000 from your bank, and you are to repay in a period of ten (12) months.
Then, the bank charges you a simple interest rate of 1 percent per month, you will calculate the effective interest as shown in the table below. Here is an example on how to calculate the effective interest rate for your loan.
|Month||Beginning Balance||Installment Payment||Principal||Interest Amount||Ending Balance|
Notes: All figures in SGD.
How Will Interest Rates Affect My Loan?
From the discussion above, interest rates determine to a large extent, whether you can repay your loan periodically as comfortably as possible. The higher the interest rate, the higher the installment.
Secondly, the type of interest offered will also determine whether you want a longer repayment term or a shorter one. A simple interest rate isn’t cheaper and would only suit a short-term loan.
With effective interest rates, your loan can take either long-term or short-term loans as interest reduces further with more payments.
The two cases illustrated show that the total effective interest is $6,618.55, which is far much lower than the simple interest of $12,000 given the same rate of 1% and 12 months. The most important factor for borrowers would be to find a lender that is able to customize a loan plan for them. Everyone’s financial situation is different. Only a personalized loan plan can help them the most.
Applying For A Loan With Favourable Interest Rates
Choosing between simple interest rates and effective interest rates for loans is a matter of economic sense.
Either can be cheaper depending on how the lender wishes to apply them. A loan given at the lowest simple interest rate may be cheaper than one given a higher effective interest rate. You will be required to make calculations to make a better judgement.
You can take a look at your monthly income or any amount of money that could be coming your way in the next few weeks. Your ability to repay helps you decide on the loan package and the interest rate.
To find a licensed moneylender that is willing to customize a loan plan just for you, click here.