To gauge the true cost of getting a personal loan, find out what the effective interest rate (EIR) is.
If you’ve spent time browsing for personal loans, you’ve probably come across two sets of interest rates attached to one singular product. The attractively low advertised rate that first caught your eye is often accompanied by a much higher interest rate known as the Effective Interest Rate (EIR).
You’ve probably been confused as to why the same product carries two interest rates. What is an EIR? And which one will you be charged if you decide to sign up?
For that matter, why are there two different rates, even if factors such as loan amount and duration remain the same?
What is the Advertised Rate?
The advertised rate (also known as nominal rate) is the interest the bank charges you on the sum you borrow.
Note that there are different ways to calculate the advertised rates, and different methods are used for different products.
What is the Effective Interest Rate or EIR?
The EIR reflects the true cost of borrowing to the consumer.
It is an interest rate that is different than the advertised rate, because it includes service fees or admin charges charged upfront for processing and approving your loan application.
Why is the EIR Higher Than the Advertised Rate?
You are familiar with the concept of interest – you pay back a higher amount than the sum you borrowed, with the difference being the interest charged. The interest charged, expressed as a percentage of the loan amount, is the nominal interest rate.
However, banks charge a variety of fees on the services they offer, such as administrative fees, which are added to the interest charged on your loan. This increases the amount you have to pay back in total.
Because you are now paying back a higher amount, your interest rate on your loan becomes higher.
This higher interest rate is the one you have to pay – i.e., it is your effective interest rate. Which is why the EIR is always higher than the advertised rate.
Are Banks Being Deceitful by Advertising the Nominal Rate?
You see, the nominal rate is the interest charged on the amount you want to borrow. It is not inaccurate to advertise it as such.
However, because of the payment of fees and charges, the interest rate on your loan becomes different from what was advertised, as explained above.
Should I Choose the Lowest EIR?
You should definitely pay attention to the EIR if you are serious about taking that loan. Remember that the EIR gives you a much better indication of the true cost of borrowing.
However, you should not automatically go for the option with the lowest EIR. This is because the EIR can change according to how the product is structured and the loan amount.
Consider a Balance Transfer with the following terms:
Advertised rate: 0%
Loan period: 6 months
One-time processing fee: S$150
Balance transfer amount: S$5,000
Balance transfer amount: S$10,000
As you can see, the EIR is vastly different between the two scenarios. Going for the lower EIR might strand you with a large outstanding balance at the end of the interest-free period, saddling you with high-interest rates.
How Can I Find Out What the EIR Is?
According to the Code of Advertising Practice for Banks, the EIR is mandatory so consumers can be aware of the true cost of borrowing. This means that banks and financial lenders must display the EIR alongside the advertised rates.
This is a good thing, as trying to calculate the EIR yourself is an exercise in madness. (Trust us, we tried.)
The only exception is if the EIR does not differ from the advertised rates. If you do not see EIR listed anywhere, you can take the advertised rate at face value. But to be doubly sure, ask your bank about the EIR on the loan you are interested in before you put your signature on anything.
Besides the EIR, ask also for the installment payment amount that you have to pay throughout the duration of your loan. Only proceed when you are sure you can meet the monthly payments for the entire loan tenor.
You can compare personal loans on SingSaver.com.sg to find the one best suited to you.
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By Alevin Chan
A Certified 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 optimize happiness and enjoyment in his life.