Calculating Effective Interest Rate vs Annual Interest Rate

If you are shopping around for a personal loan, you have no doubt seen banks advertise two different interest rates: Annual Flat Rate and Effective Interest Rate (EIR). If you are confused by how these are different and what you should care about, you are not alone. Banks do not quite explain or demonstrate why and how these two rates are different, or how to even calculate them. Not only that, some sites say that you can just look at effective interest rate, which is not entirely correct. Though EIR is a bit more important than the flat rate, we think it’s important to understand both concepts so you can make a fully informed financial decision.

Table of Contents

• Difference Between Annual Flat Rate and Effective Interest Rate
• How to Calculate Effective Interest Rate

Difference Between Annual Flat Rate and Effective Interest Rate

Annual flat rates are quite simple. Every year that you are borrowing from a bank, the bank charges you a flat rate of x% on your principal until you pay the money back. For example, if you borrow S$5,000 at 6% for 1 year, you have to pay S$30 in interest every month. This is very important to understand because your annual flat interest rate will decide how much you have to pay to the bank every month. When people say that EIR is the only thing that matters in a personal loan, don’t take their advice. When you take out a loan from a bank, you have to make sure the monthly payment is something you can comfortably handle.

Effective interest rate, on the other hand, is important because it represents the true economic cost of carrying a personal loan. However, it can be a bit confusing to understand, especially because banks don’t explain this concept fully. Like the screenshot of a bank's website below demonstrates, just about the only thing that banks usually say about effective interest rate is that it takes into account the impact of a processing fee. A personal loan in Singapore usually comes with an upfront processing fee that ranges from 2% to 4% that can be up to S$200, which is typically deducted from your loan right off the bat. Since this is a cost, banks will calculate how much this fee increases your effective interest rate.

However, that’s not the only thing causing your EIR to be much higher than the advertised flat rate. The crucial concept to understand is that you don’t get to use the full amount you borrowed for the entire duration of your loan. That’s because the monthly payment you make to the bank includes both your interest and principal payment. In other words, you are paying some money back every month but that has no impact on reducing your interest payment.

In contrast, credit card debts will not operate the same way. Even if you have an unpaid balance on your card in one month, you will not be charged interest on that balance in the next month if you have paid down this debt already. This is a why credit cards in Singapore can be free to use despite the high 25% interest rate so long as you pay your balance in full every month. To account for this concept, you have to use a different calculation method, which we explain in more detail below.

How to Calculate Effective Interest Rate

Calculating effective interest rate is actually a rather complicated process. You need to take into account interest rate based on reduced balance of your loan, which changes every single month. First, you need to calculate what the balance of your loan you will be carrying on average throughout the duration of the loan. Since you are paying back an equal amount of principal every month, the average of your principal is actually just about half of the principal. If you took out a loan of S$5,000, then the average will be S$2,500.

Then, you can calculate the total interest you will be paying by the following calculation: Principal x Flat Interest Rate x Loan Tenor. For example, a personal loan in Singapore costs an average interest rate of 7%. Then, a personal loan of S$5,000 over 3 years will have cost you a total of S$1,050 in interest. Adding your 3% processing fee (S$150) to the interest payment will get you the total cost of carrying the loan. Dividing the total cost (S$450+S$150 = S$1,200) by your average balance (S$2,500) and the duration of the loan (3 years) can get you the approximate effective interest rate of your loan. In this example, it’s about 16%, roughly 2.3x higher than the 7% of annual flat rate.

If you don’t want to do the math on your own, effective interest rates are usually 1.8x to 2.5x higher than flat interest rates, after accounting for fees. Also, the Ministry of Law of Singapore has a nice effective interest rate calculator that you can use to calculate how your flat rate translates into your effective interest rate. Simply enter the duration of your loan, principal, frequency of payment and flat interest rate, and it should spit back out the magic number.

Conclusion

When evaluating a personal loan in Singapore, it’s extremely important to consider both annual flat rate and effective interest rate. While EIR is the true economic cost of the loan that takes into account processing fees, annual flat rate will also determine whether or not you can handle the monthly payment you need to make for the next 12 to 60 months, depending on the tenor of your loan.

That is not to say, however, that EIR is not as important. When comparing one loan to another, what will ultimately determine which debt is “cheaper” is EIR. Make sure you carefully study and understand total costs involved in taking out a personal loan, and that your monthly finances and budgets are able to manage the regular payment which a personal loan will entail. Your goal should be to find balanced personal loan with the low interest rate, low total cost and manageable monthly installments.