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