How to Understand Loans: Simple vs Effective Interest Rates

Choosing the right type of loan can make a world of difference

We often take out loans to finance homes, cars, and other personal expenditures; however, not all loans are the same. The type of loan you take out will impact the cost of the credit.
Use the effective interest rate to decide which loan has the best rate - it's not always the first number they show you!
Given the same loan amount, interest and tenor, a loan calculated on a monthly rest (reducing balance) basis will be cheaper than one calculated on a flat rate basis.

Not all loans are the same, there are two types of loans: flat rate vs reducing balance. Each uses the stated interest rate differently!

Determining the Rate: Fixed vs Floating

Fixed interest rates vs floating interest rates

The interest rates stated in your loan are either fixed or floating. Fixed means that your interest rate will stay the same throughout a specified period, known as the lock-in period, or the entire loan tenor. On the other hand, floating interest rates will vary and can go both up and down, following the interest rate observed in the market.

In Singapore, the interest rate often observed is SIBOR, the Singapore Interbank Offered Rate, which will gradually be replaced by SORA, the Singapore Overnight Rate Average.

Reading What’s Given: Simple vs Effective

When you’re considering a loan, the bank will present you with two different interest rates: simple interest rate and effective interest rates. Both interest rates are referring to the same loan, but their values may be different. Why is that? Let us first take a look at what each interest rate represents.

Simple Interest Rates

Simple interest rates, also known as advertised interest rates, are rather… simple. It is the nominal interest rate charged on your outstanding loan. The 3.5% used in both the examples above (the flat rate loan and the reducing balance loan) will be your simple interest rate.

However, the simple interest rate does not truly reflect the cost of a flat rate loan, and this is because a flat rate loan does not consider the following:

1. Processing fee

When taking out a loan of any type, you’ll likely have to pay a processing fee, which may be substantial. The processing fee is charged in three different ways. It may be:

An upfront payment made upon loan approval or on the first instalment date
Deducted from the funds you receive from the loan (the disbursement)
Added into your loan principal that you have to repay during the tenor

2. Decrease in outstanding loan amount

The simple interest rates of the reducing balance loan will also not reflect the true cost, as the calculations do not consider the processing fee.

As such, under the Code of Advertising for Banks, it's compulsory for banks to show the effective interest rate of any interest-bearing loans. This is because it better reflects the true cost of credit. Just don’t expect this generous treatment from loan sharks as well.

Bank of England — Photo by Etienne Martin on Unsplash

Effective Interest Rates (EIR)

The effective interest rates on loans demonstrate the true cost of credit, as the interest rate is calculated based on the loan’s outstanding balance every month and not the principal amount. It also considers any other fees involved with the transaction.

We can calculate an estimate of the EIR when comparing a flat rate loan and a reducing balance loan. We do this using the same tenor, instalment period and loan amount. We ignore the upfront processing amount when making this comparison since it will be the same cash amount charged in both scenarios.

Recall that both types of loans use the simple interest rate differently. As we are ignoring the upfront processing amount, the advertised Reducing Balance Loan interest rate will equal the EIR. Hence, the EIR for reducing balance loan is 3.5%. So, we will only need to find the flat rate loan’s EIR.

To find the EIR of a flat rate loan, we pretend that it is a reducing balance loan. We use the same principal amount, tenor, instalment period, and monthly payouts but ignore the simple interest rate given. Using the actuarial method, we can find the EIR to be 6.53%, which is much higher than the simple interest rate of 3.5%.

For a loan with the same tenor, instalment period, and loan amount, a reducing balance loan structure will always have a lower EIR than a flat rate loan structure due to how interest is charged.

*Processing fee is treated as though it's been added to the loan principal. While it may not be the actual practice in your loan agreement, it is a good method to think about the cost you bear.

Direct-Ratio Method

The actuarial method may be the most accurate, but it is a hassle to calculate. A faster way to estimate your EIR is by using the direct-ratio method. However, this method tends to underestimate the EIR slightly.

First, we'll calculate the cost of credit.

Cost of Credit = N x D + P - L

N is the total number of payments to be made

D is the monthly instalments

P is the processing fee or any other one-off financial costs

L is the original loan amount

Secondly, we'll use the following formula.

EIR = 6 x M x C / [3 x L x (N+1) + C x (N+1)]

M is the number of payments in a year

C is the cost of credit

L is the original loan amount

N is the total number of payments to be made

Using the Direct-Ratio Method for the example above,

Cost of Credit

= 60 x 39.16 + 0 - 2000

= 350

Effective Interest Rate

= 6 x 12 x 350 / [3 x 2000 x 61 + 350 x 61]

= 6.51%

A ballpoint pen placed on a white paper with math equations on the paper — Photo by Antoine Dautry on Unsplash

Discount on Car Price

What if you’re offered a discount on the car price if you take out a loan with them instead of using cash? Well, that depends! Ultimately, you need to establish whether the total amount of interest you’ll pay on the loan is higher or lower than the discount on the car price. If the total interest is higher than the discount on the car price, then no, don’t take up the offer.

Additional costs of loans

We’ve already discussed processing fees, but it’s worth noting the additional extra costs to loans that you should factor into your calculations:

Amendment fee: regards the waiver of or agreement to amend or change to the original loan application.

Cancellation fee: if the loan is not taken up or drawn down after acceptance.

Excess charges: if more money than the original overdraft limit is taken out.

Late payment charges: for not paying the agreed amount by a payment due date.

Default charges: for the absence of payment.

Early repayment charge: if you think that you’ll be on good terms with your lender for paying back part/all of your loan earlier than agreed, think again! There’s a charge for this!

SIMPLE vs EFFECTIVE INTEREST RATES. COMPLETED ✅

Sources:

MoneyFitt (ProConnect Technologies Pte Ltd) is not responsible for any errors or omissions, or for the results obtained from the use of this information and shall also not be liable for any damage or loss of any kind, howsoever caused as a result (direct or indirect) of the use of the app and its features, including but not limited to any damage or loss suffered as a result of reliance on the app. All information is provided “as is”, with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information. The information contained is not intended to be a source of advice or credit analysis with respect to the material presented. Any ideas and strategies should never be used without first assessing your own personal and financial situation, or without consulting a financial, tax or legal professional and independently researching and verifying information. We do not provide any financial advice, nor are we licenced to.