What Is Effective Interest RateOn Loan And How Is It Calculated?
Loansare confusing, especially when determining the true cost of borrowing. For example, when shopping for a loan, you may have come across the term “Effective Interest Rate” or EIR, but what exactly is it?
The effective interest rate on a loan takes into account both the interest and other fees charged by the lender, making it a more accurate representation of the true cost of the loan.
Understanding EIR is crucial when making informed decisions about your finances. In this article, we’ll dive deep into the effective interest rate on loans and how it is calculated.
What Is the Simple Interest Rate?
A simple Interest Rate is a basic type of interest rate calculation where the interest is calculated based on the principal amount and the period for which the loan is taken.
Unlike the effective interest rate (EIR), a simple interest rate does not factor in the compounding effect, when the interest earned is added to the principal to calculate the next interest.
This leads to a lower interest rate but can result in a higher overall cost if the loan period is long. Therefore, a simple interest rate is most commonly used for short-term loans, such as personal or car loans, where the loan period is relatively short, and the compounding effect is insignificant.
What Is EIR?
Effective interest rate (EIR) is a more comprehensive measure of a loan’s cost than the simple interest rate. It considers the frequency of compounding interest and fees associated with the loan.
So, unlike a simple interest rate, EIR gives you a more accurate picture of the total cost of the loan, including interest and fees over the full term.
This makes EIR an important consideration when taking out loans for home renovations, investment properties, or even personal loans. By understanding EIR, you can make more informed decisions about the loans you take out and ensure you get the best deal possible.
How To Calculate Effective Interest Rate
Calculating a loan’s Effective Interest Rate (EIR) can be a bit more complicated than calculating the simple interest rate. However, with the right information and some math, it’s possible to determine the EIR for any loan you’re considering.
To calculate the EIR, you’ll need the following information:
- The nominal interest rate
- The loan amounts
- The loan tenure
- Any fees associated with the loan (e.g., processing fees)
Once you have all this information, use the following formula to calculate the EIR:
EIR = (Nominal Interest Rate + Fees) / (1 – (1 + Nominal Interest Rate) ^ -Loan Tenure)
For example, let’s say you’re considering a loan with a nominal interest rate of 4% and a processing fee of $100. The loan amount is $10,000, and the loan tenure is 36 months. Using the formula above, we can calculate the EIR as follows:
EIR = (0.04 + 100 / 10000) / (1 – (1 + 0.04) ^ -36) EIR = 0.05 or 5%
In this example, the effective interest rate is 5%, higher than the nominal interest rate of 4%. Again, this is because the processing fee increases the overall cost of the loan, even if it’s not reflected in the nominal interest rate.
Similarly, the following table shows the loan amount, interest rate, loan tenure in months, and repayment amount to calculate the Effective Interest Rate for each loan scenario:
| Loan Amount | Interest Rate | Loan Tenure (months) | Repayment Amount | Effective Interest Rate |
|---|---|---|---|---|
| $10,000 | 5% | 12 | $1,000 | 10.35% |
| $20,000 | 6% | 24 | $2,000 | 6.13% |
| $30,000 | 7% | 36 | $3,000 | 7.01% |
Why Are Effective Interest Rates Typically Higher Than Advertised Rates?
When comparing loans, it’s common to look at advertised rates to compare the cost of credit.
However, advertised rates may not always provide a full picture of the total cost of borrowing. This is because they don’t consider the effect of compounding, which occurs when interest is charged on both the principal and any accumulated interest.
To get a more accurate picture of the cost of borrowing, it’s important to look at the EIR, which takes into account the effect of compounding.
As a result, the EIR is typically higher than the advertised rate and provides a more accurate representation of the total cost of borrowing over the entire loan term.
Here’s an example to demonstrate this point:
| Loan 1 | Loan 2 |
|---|---|
| Advertised Rate: 4% | Advertised Rate: 6% |
| Loan Amount: $10,000 | Loan Amount: $10,000 |
| Loan Term: 36 months | Loan Term: 36 months |
| EIR: 4.2% | EIR: 6.3% |
In this example, while Loan 1 has a lower advertised rate, the EIR is higher than Loan 2. This means that Loan 1 may still be more expensive in the long run despite the lower advertised rate.
Therefore, when comparing loans, it’s important to look beyond advertised rates and consider the EIR to get a more accurate picture of the cost of borrowing.
How To Choose The Best Loan
When choosing the best loan, it’s important to consider both the interest rate and the Effective Interest Rate. The interest rate is the cost of borrowing money, while the Effective Interest Rate considers other fees and charges associated with the loan.
To choose the best loan, consider these factors:
- Loan amount: Consider how much you need to borrow and whether the loan amount you’re eligible for meets your requirements.
- Loan tenor: Consider how long you need to repay the loan and whether the loan tenor is suitable for your financial situation.
- Fees: Look at the fees associated with the loan, such as processing fees, late payment fees, and prepayment penalties.
- Interest rate: Compare the interest rates of different loans and choose the best rate.
- Effective interest rate: Compare the effective interest rates of different loans and choose the best overall value.
Here is an example:
| Loan Type | Advertised Rate | Effective Interest Rate |
|---|---|---|
| Loan A | 5% | 6% |
| Loan B | 6% | 5% |
In this scenario, Loan B may seem like the better option as the advertised rate is higher than Loan A, but when looking at the Effective Interest Rate, Loan A has a lower rate of 6% compared to Loan B’s 5%.
This is because the Effective Interest Rate considers all the fees associated with the loan. Therefore, when choosing the best loan for your needs, it is important to consider both the Advertised Rate and the Effective Interest Rate.
Ready To Apply For Your Loan?
If you’ve made it this far, you’re now well-informed about what is effective interest rate on a loan is and all the important factors to consider when choosing the best loan.
You can make a well-informed decision when applying for your loan with a clear understanding of its effective interest rate, how it’s calculated, and why it’s typically higher than advertised rates.
Take your time to compare loan options, consider the EIR, and make an informed decision.
Horison Credit is here to help you every step of the way, so don’t hesitate to contact us and see how we can help you secure the best loan for your needs. So, apply for your loan and get one step closer to realising your financial goals!
