How to Calculate Loan Interest Rates

Alevin Chan

Alevin Chan

Last updated 17 April, 2024

Learn what the interest rate on your loan actually means, how loan interest is calculated, and the factors that impact the interest. 

Loans are a common feature of our modern lives. They are necessary for funding high-cost expenses such as home mortgages and car loans, and are also very useful for ad-hoc expenditures and to cope with financial emergencies. 

One of the most important things to know about a loan is the interest rate. While interest rates may be presented as small numbers, the total amount of interest paid by the end can be anything but small. 

In this article we will look at how loan interest rates are calculated, how they affect your payments, and why it is important to consider both the advertised rate and the effective interest rate. 

Table of contents

Understanding how to calculate loan interest 

Loans in Singapore are calculated in two ways – flat rate or monthly rest rate. The difference between the two is the amount of interest that makes up each instalment. 

Flat rate loan

In a flat rate loan, the interest is calculated based on the principal loan amount. The amount of interest paid for each instalment remains the same throughout, while the amount paid to the principal reduces over time. 

Commonly, the flat rate calculation method is used for car loans. A large majority of personal loans in Singapore also follow the flat rate method. 

Example of flat rate loan calculation

Let’s assume a S$90,000 car loan at a 2.5% per annum flat interest rate. Here’s what your repayment would look like. 

 

5-year term

7-year term

Monthly payment

S$1,687.50

S$1,258.93

Total amount paid

S$101,250

S$105,750.12

Interest pair

S$11,250

S$15,750

Source

Here's another example of a personal loan calculation from CIMB. Assuming a loan of S$10,000 at 3.38% p.a. for three years, below is the amount you'll be paying. 

Loan amount

S$10,000

Interest rate

3.38% p.a. (EIR 6.38% p.a.)

Tenure

Three years

Processing fee

0%

Total interest payable

3.38% p.a. x S$10,000 x three years = S$1,014

Total repayment

S$11,014

Monthly instalment

S$306.00

 

Monthly rest rate loans

In a monthly rest rate loan, the interest charged is based on the outstanding principal amount. This means that the amount paid for interest is initially high but reduces over time. However, the amount paid into the principal increases as the interest amount decreases, so you will still be paying a fixed amount each month. 

Home loans are the most common examples of monthly rest rate loans.

Example of monthly rest rate loan

For this example, let’s assume a home loan of S$600,000, with 3.5% p.a. fixed rate interest, and a 20-year term. The fixed payment each month is S$3,480.

Here’s what your payments would look like.

Mortgage year

Principal paid each month (A)

Interest paid each month (B)

Total paid each month, rounded (A+B) 

1

S$1,729.76

S$1,750

S$3,480 

2

S$1,791.28

S$1,688.48

S$3,480 

3

S$1,854.99

S$1,624.77

S$3,480 

4

S$1,920.97

S$1,558.79

S$3,480 

5

S$1,989.29

S$1,490.47

S$3,480 

Source

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Flat rate vs monthly rest rate

Here’s how both calculation methods compare to each other at a glance. 

 

Flat rate

Monthly rest rate

Interest based on 

Principal sum borrowed

Outstanding principal amount

Amount paid into interest

Remains fixed throughout

Decreases over time

Amount paid into principal

Remains fixed throughout 

Increases over time

Total amount paid each month

Does not change between months

Does not change between months


Advertised interest rate and effective interest rate

You often see two sets of interest rates attached to loans in Singapore. These are the advertised interest rate (AIR) and the effective interest rate (EIR)

The AIR is what it says – it is the rate that is used in advertisements regarding the loan. Meanwhile, the EIR represents the real cost of taking the loan.

Depending on the method of calculation used in the loan – flat rate or monthly rest rate – the AIR and EIR can differ. 

  • In a flat rate loan, the EIR is higher than the AIR because the same rate (advertised rate) is applied throughout the loan period based on the original loan amount. 
  • In a monthly rest rate loan, the AIR is the same as the EIR because interest is calculated based on the reduced balance of the loan.

Additionally, EIR can also be impacted by the frequency of payments. This is because of the way EIR is calculated.

Here’s the formula for EIR: [(1 + (nominal interest rate/no. of compounding periods) ^ (no. of compounding periods)]  – 1

But instead of doing our own calculations, we can make use of an online calculator to observe the effect of the frequency of compounding in EIR. 

Let’s assume a loan with a 10% p.a. advertised interest rate. The loan tenure is 1 year.

EIR

Frequency of compounding

10%

1 (interest is charged once during the loan)

10.3813%

4 (interest is charged every quarter)

10.426%

6 (interest is charged every two months)

10.4713%

12 (interest is charged monthly)

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Use EIR to compare loans

As you can see, the more frequently your loan is compounded, the higher the total interest you have to pay. This also means that the longer you borrow, the more interest you will end up paying. 

Hence, you should always check the EIR for different loan tenures so you can choose the most cost-effective loan package for you. 

Knowing the EIR can also help you accurately compare different loan packages. Generally, you should choose the one that offers the lower EIR, as it would be the cheaper loan. 

However, it’s also important to check that the loan fits your needs and preferences, such as how much you can borrow and the repayment duration. 


Factors that impact how much interest you pay

Amount borrowed

The larger the sum borrowed, the more interest you will need to pay. This is because loan interest is charged based on the principal sum.

Loan tenure

Generally speaking, choosing a longer loan tenure results in higher total interest paid. However, you choose a loan tenure according to your ability to meet the monthly repayments. Otherwise, you will incur fees and charges that increase the cost of your loan.

Fees and charges

Besides late fees, you should also watch out for other fees such as admin or registration charges. These can raise your total interest paid. For instance, a 1% admin fee on a S$100,000 raises your cost of borrowing by an extra S$1,000. This also jacks up your EIR. 

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Frequently Asked Questions (FAQs)

Why do banks charge interest?

Banks and lenders charge interest for furnishing the loan to you. The interest earned on your loan is one way they generate revenue. 

Unsecured loans, such as personal loans, are provided without collateral, which means greater risk to banks. To compensate for taking on increased risk, personal loans have higher interest rates compared to, say, a home mortgage, which is collateralised by your property. 

What is “principal amount”?

The principal amount is the sum you borrow from the bank. Based on this principal, the interest rate is applied, along with relevant fees. The total amount paid by the end of the loan, minus the principal sum, will give you the cost of borrowing.

How to calculate the total interest paid?

For flat rate loans, the formula is: 

  • principal amount x interest rate x no. of years of the loan tenure. 

Hence, for a S$30,000 flat rate loan with a 8% p.a. interest and 5 year loan tenure, the interest is S$30,000 x 0.08 x 5 = S$12,000 total interest paid.

For monthly rest loans such as a home mortgage, the calculation is rather complicated. We recommend using an online calculator to find out your total interest paid.

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An ex-Financial Planner with a curiosity about what makes people tick, Alevin’s mission is to help readers understand the psychology of money. He’s also on an ongoing quest to optimise happiness and enjoyment in his life.

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