If you're researching personal loan options, you'll likely come across the term effective interest rate (EIR). This is an important concept to understand because it provides borrowers with a standardised way of comparing different loan options and calculating the total cost of a loan over time. In this blog, we'll explain what EIR is, what it means in the context of personal loans, and how to calculate it.
What is an Effective Interest Rate (EIR)?
First, let’s define the meaning of EIR:
Effective Interest Rate (EIR) is the total cost of borrowing a loan, expressed as a percentage of the amount borrowed. Unlike the annual interest rate, EIR takes into account the impact of compounding. While annual interest rates only calculate the percentage of interest applied to the loan amount each year, EIR considers additional factors such as number of instalments, frequency of instalments, and the instalment amounts to give you a better idea of the total cost of borrowing.
Why Not Just Use the Annual Interest Rate?
Financial institutions often like to advertise their low annual interest rates because it's appealing to borrowers. However, borrowers should always look at the EIR for a better idea of the total interest accumulated over time and use it to compare loans from different lenders.
For example, Bank A and Bank B might both be offering a personal loan with an annual interest rate of 5%. However, Bank A might offer a longer loan duration with more instalments while Bank B might structure the loan differently. By putting everything into a level playing field, EIR would make it easier to compare the two loans and calculate the total cost of borrowing each one.
As of 2023, all financial institutions in Singapore are required to provide the EIR of their loan products to customers. This ensures that customers can easily compare different products and make an informed decision.
How Do You Calculate EIR?
Banks and financial institutions are required to include additional costs like admin fees in the EIR they calculate for customers. However, to keep things simple, let's look at how EIR is calculated in a scenario where there are no additional fees.
The formula for calculating EIR would be as follows:
EIR = (1 + r/n)^n - 1
Where r is the annual interest rate, and n is the number of compounding periods.
To illustrate with an example: let's say you take out a loan for $10,000 with 12 monthly instalments of $875 each at a 5% annual interest rate. To calculate your EIR, you first divide the annual interest by 12 to get 0.04167%. You then plug this figure into the formula above:
EIR = (1 + 0.04167%/12)^12 – 1 = 5.2%
This means that in total, you will be paying back $10,520 over the course of your loan, resulting in an EIR of 5.2%.
You can save time by using an online EIR calculator, or better yet, use a trusted loan comparison platform like Lendela to compare and pinpoint out the lowest interest rate personal loan in Singapore within minutes. Since Lendela only partners with reputed licensed banks and financial institutions in Singapore, you are sure to avoid loan sharks that prey on unsuspecting clients online.
Should You Go for The Loan with The Lowest EIR?
Generally speaking, going for the lowest EIR is a pretty reliable and cost-effective option. However, borrowers should also take the time to consider other important factors, such as repayment flexibility and loan terms when making their decision.
For example, if you're looking for a loan that can be repaid over a longer period of time, it is better to go for one with a more flexible repayment structure even if its EIR is slightly higher. On the other hand, if you have sufficient cash flow to meet your monthly instalments, then a lower EIR loan may be the most cost-effective option.
Longer Loan Equals Lower EIR...But More Interest Overall
It's important to note that a longer loan term usually results in lower EIR, but more interest overall. For example, with the same loan amount and annual interest rate of 5%, if you increase your instalment schedule from 12 months to 24 months, you might see a drop in your EIR from 5.2% to 4.7%. However, even though you're paying less each month over a longer period of time, you’ll be paying more in total over the two-year period due to additional compounding interest applied.
How Much Can You Afford to Pay Back Every Month?
Some financial institutions will offer you a lower EIR if your loan has a shorter tenure. However, this usually means a higher monthly repayment, and having to pay back so much money straight away might put you into financial stress. You should also take into consideration of other risk factors, such as the increment of late fees and penalties when you are unable to repay your instalments in full and on time.
In summary, here is what an average loan borrower should know about EIR, and how it can be used to help compare different loan options:
Unlike annual interest rates, which only gives you a brief idea of how much interest you are paying, EIR takes into account additional factors such as number of instalments, frequency of instalments and the instalment amounts to give you a better idea of the total cost of borrowing.
EIR makes it easier for borrowers to compare loans from different financial institutions because it puts everything into a more level playing field than annual interest rates.
Choosing the loan with the lowest EIR is generally a good idea, but you should still consider other factors, such as the total interest payable and the amount of each instalment.
If you want to get the lowest EIR personal loan from banks and licensed financial institutions in Singapore, try out Lendela's service now. Instead of researching 20 banks' websites and comparing their loan rates one by one, Lendela lets you fetch and compare pre-approved personal loan offers from multiple institutions at once with a few clicks of a button. Compare loan terms such as loan amount, EIR, tenure, and fees from different lenders and enjoy shorter application and approval time. See all your cash loan offers at a glance with Lendela today.