Taking Up a Loan? Why You Should Know About Effective Interest Rate

When you borrow loans, you must repay them with interest. There are two ways to pay for a loan - you can pay more interest with longer tenure and pay lower interest with shorter tenure. Usually, you hear about interest rate when you pay for loans you’ve taken. You must know what is the effective interest rate to compare different loans to get the best rate. This helps you calculate the trust cost of taking up a loan. Let’s dig in to know more about the effective interest rate.

What is the effective interest rate?
Effective interest rate (EIR) is the rate that you, as a borrower, incur in a year after adjusting to compounding. The higher the number of compounding periods, the higher the EIR will be. In EIR, banks and licensed lending institutions consider processing, loan schedules, and admin fees to calculate EIR for a loan.

This is how EIR is calculated:

[ (1 + (nominal interest rate / no. of compounding periods) ^ (no. of compounding periods) ]  – 1

Should you pick a loan with the lowest EIR?
It is not a wise decision to go for a loan with the lowest EIR. You should choose a loan product depending on the structure of the credit product and the loan amount.

Ask the licensed money lender or bank
When you borrow money in the form of a personal loan, housing loan, or car loan, always ask the bank or lender to explain the EIR as well as the annual rate. The Singaporean law mandates lenders to publish the EIR value on the loan documentation.

Other loan costs
As a borrower, it is mandatory for you to pay the principal amount and the interest rate when you take a loan. But there are other costs that need to factor into your calculations, such as amendment fee, cancellation fee, excess charges, late payment fee, early repayment charge, and default charges.

Conclusion
When you want to earn passive incomes, you learn how to invest in stocks in Singapore. Similarly, when you want to borrow money from a lender, you must know what the effective interest rate is. This helps you determine the true economic cost of a loan. It could eventually help you pay exactly what you were prepared for.