We often see the terms effective interest rates and simple interest rates for loans. Banks and licensed moneylenders in Singapore will advertise their loan packages with these terms. These terms are not usually explained. Some websites may also suggest looking at effective interest rates only. However, it is better to look at both.
When taking out a loan, you need to be aware of two types of interest rates: effective interest rates and simple interest rates. Both rates have advantages and disadvantages, so it’s essential to understand their differences.
In this article, we will compare effective interest rates vs simple interest rates for loans to help you know the type of loan right for you.
Table of Contents
What is Simple Interest Rate?
A simple interest rate is the amount of interest charged on loan without considering any compound interest. Therefore, you will only be required to pay back the original loan amount plus the simple interest. It is a direct and flat interest rate.
For example, if you take out a $100 loan with a simple interest rate of 15%, you will owe $115 after one year.
The main advantage of a simple interest rate is that it’s easy to calculate interest rate and understand. The downside is that it doesn’t consider the time value of money, which means you could pay more in total interest over time.
Simple Interest Rate Formula
What is the formula for simple interest rate? The simple interest rate formula is I=PRT, where: I = Simple Interest Amount (the amount you will pay in interest), P = Principal (the original amount of the loan), R = Annual Interest Rate (as a decimal), T = Loan Term (in years).
How to Calculate Simple Interest?
To determine the simple loan interest rate, you will need to know the following;
- The principal amount of the loan (P)
- The annual interest rate (R)
- The loan term in years (T)
Once you have all this knowledge, you can plug it into the formula and calculate the interest you will owe.
Loan Example
Let’s say you took out a $1,000 loan with a 15% annual interest rate. What would the simple interest be if you borrowed the amount for one year? Likewise, find out the simple interest if the amount is owed for two years, four years, or six years?
Result:
| Loan Tenure | Simple Interest |
|---|---|
| 1 Year | S.I = (1,000 ×15 × 1)/100 =$150 |
| 2 Years | S.I = (1,000 ×15 × 2)/100 =$300 |
| 4 Years | S.I = (1,000 ×15 × 4)/100 =$600 |
| 6 Years | S.I = (1,000 ×15 × 6)/100 =$900 |
What is the Effective Interest Rate?
The Effective Interest Rate (EIR) is the actual cost of borrowing money, considering compound interest.
Therefore, you will not only be required to pay back the principal amount of the loan plus any simple interest but also be charged interest on the interest that has accrued over time.
Why is the Effective Interest Rate Crucial?
The effective interest rate is essential because it allows you to compare different loan products on a level playing field. When looking at loans, the advertised interest rate is usually simple.
It can be misleading, as it doesn’t consider the compound interest that will accrue over time. The effective interest rate takes this into account, giving you a more accurate picture of the actual cost of borrowing money.
Effective Interest Rate Formula
The effective interest rate formula is: EIR = (P + I) / P – I where:EIR = Effective interest rate P = Principal (the original amount of the loan) I = Simple interest rate.
Therefore, the effective interest rate is calculated by adding the simple interest rate to the principal and then dividing by the principal minus the simple interest rate.
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How Will Interest Rates Affect My Loan?
The interest rate you’re offered on a loan can have a significant impact on the total cost of your loan.
Let’s add some numbers to illustrate. For example, let’s say that you’re considering two loans:
- Loan A has an effective interest rate of 15%
- Loan B has an effective interest rate of 20%.
- Both loans have the same principal amount and loan term.
Assuming that you make all of your payments on time, Loan A will cost you $11,251 in total interest, while Loan B will cost you $13,003 in genuine interest.
It means that even though Loan B has a lower advertised interest rate, it will cost you more money in the long run. Therefore, it’s essential to understand the effective interest rate when taking out a loan. When comparing loans, look at the effective interest rate, not just the advertised interest rate, because it will give you a more accurate picture of the actual cost of borrowing money.
Measures to Take When Interest Rates Increase
If you have a loan with a variable interest rate, you need to be prepared for an interest rate increment. Variable interest rates will change when there are changes in the world economy. If the US interest rate increases, our interest rates may increase too. Some of the measures that you can take to protect yourself include;
1. Make a Larger Downpayment
The larger your down payment, the less money you will need to borrow. With a lower principal amount, cost of interest will be lower. It will reduce the amount of interest that you will accrue over time.
2. Increase Your Monthly Payments
You can pay off your loan more quickly by increasing your monthly payments. Therefore, it will lower the interest you will pay over time.
3. Reduce Your Repayment Term
If you can, you can also reduce your repayment term, enabling you to pay off your loan more quickly and pay less interest over time.
4. Pay Off Credit Card Balances
If you have a credit card with a balance, make sure you pay it off in full each month, as you will only be charged the simple interest rate and not the compound interest rate. Credit card compounds interest over time and your bill could come shockingly high! Read more about credit cards and their charges here.
5. Get a Fixed-Rate Loan
If you can, you should try to get a loan with a fixed interest rate. As a result, your payments will stay the same even if interest rates go up. Therefore, it will enable you to protect yourself from an interest rate increase.
6. Consider a Debt Consolidation Loan
You may need to consider a debt consolidation loan if you have multiple debts with different interest rates. It can help you get a lower interest rate on your overall debt and make it easier to manage your payments.
7. Make Extra Payments When Possible
You can make an additional payment on your loan if you have some extra money. It will reduce the interest you will pay over time and help you clear your loan more quickly.
Wrapping Up
Comparing effective interest rates VS simple interest rates for loans is vital to get a more accurate idea of the actual cost of borrowing money. The effective interest rate considers compound interest, while the simple interest rate does not.
Therefore, it can make a big difference in the total cost of your loan. When comparing loans, look at the effective interest rate, not just the advertised interest rate, as it will give you a more accurate picture of the actual cost of borrowing money. To get a free loan estimate, submit online here.
