Understanding effective interest rates (EIR) is essential for making an informed comparison between different loans. This guide will walk you through the basics of effective interest rates, including what you can realistically expect based on your credit history.
Many of us hold the misconception that the interest rates we end up paying on a loan are the exact interest rates as advertised by the provider. This is often far from the truth.
Interest rates quoted by providers are usually the advertised interest rate. This calculation only includes the interest payable on the amount you’ve borrowed. In reality, you’re more likely to end up paying the effective interest rate, which further includes fees for administration and application processing. Effective interest rates are thus a more accurate gauge of how much you could end up paying on a loan.
The effective interest rate on a loan is found alongside the advertised interest rate, in accordance with regulations by the Code of Advertising Practice for Banks. If you cannot locate the effective interest rate, this could mean that it does not differ from the advertised interest rate. Always clarify with your provider as an added measure of precaution.
What's an interest rate?
An interest rate is the percentage of your loan balance that you have to pay back in addition to the amount you borrowed. With personal loans, lenders often charge you interest with each scheduled repayment — usually once a month. Your monthly repayment actually has two parts: A repayment on your balance and an interest payment.
As your balance gets lower, the amount in interest decreases since it’s a percentage of that balance. Your payments on the balance, however, increase so you end up paying the same amount each month.
Why should I care about effective interest rates?
Comparing effective interest rates on different loans with the same term could help you root out the least expensive one. That’s because the interest rate alone doesn’t take into consideration how much fees impact your payments.
The most common fee associated with personal loans is a processing fee, which covers application costs. These tend to range from 1% to 6% of your loan amount and are subtracted from your funds before you receive them.
Let’s look at an example: Say you wanted to borrow S$10,000 and repay it over 5 years. You applied with two lenders and this is what they offered:
First lender
Second lender
Interest rate
11%
9%
Processing fee
1% (S$100)
6% (S$600)
EIR
11.43%
11.52%
Monthly payment
S$219.60
S$220.04
The second lender looks like a better deal when you look at the interest rate alone. But when you factor in the processing fee, it’s clear the difference is not nearly as big — even more apparent when you look at the monthly payment.
Compare effective interest rates from personal loan providers
Pro tip: Compare effective interest rates for loans with the same repayment term for the best results
Your loan term is an easy-to-forget factor that goes into determining your effective interest rate.
How does this work? Looking at the previous example. Say you wanted to borrow S$10,000 from the first lender with the 11% interest rate but weren’t sure how much time you wanted to take to pay it back. Compare two different loan terms:
24-month term (2 years)
60-month term (5 years)
EIR
12%
11.43%
Monthly payment
S$470.74
S$219.60
Total interest paid
S$1,197.74
S$3,075.91
Total loan cost
S$11,297.74
S$13,175.91
Three things become clear when you look at this comparison: A shorter loan term can increase your effective interest rate, increase your monthly payments but lower your overall loan cost.
Higher effective interest rates for shorter-term loans aren’t necessarily more expensive — in fact, the opposite could be true. That’s why it’s more effective to compare loan effective interest rates with similar terms. The lowest effective interest rate for the same loan term is, in fact, the least expensive.
What’s a good effective interest rate on a personal loan?
Since effective interest rates are heavily dependent on your personal credit score, it’s hard to say what makes a good overall rate.
Personal loans come with effective interest rates that range from 7% to 25%, though you can sometimes find an effective interest rate as low as 6%. The lowest rates are available for people with good or excellent credit, while higher rates tend to go to those with low credit or a poor credit history. In general, most borrowers prefer loans with the lowest effective interest rate. However, do take note that this doesn’t always guarantee the lowest payments. You’ll have to consider a range of factors alongside your effective interest rate in order to determine your final payment costs. Such factors include your loan tenure and monthly income.
Don't be fooled by starting EIRs: They're only for people with perfect credit
We’ve all done this: Looked at the lowest possible rate on a loan and assumed it’s the rate we’d get. In reality, those low rates only apply to the small group of people who have absolutely perfect credit.
To get a better idea of what you can expect with a lender, fill out a prequalification application or use a calculator to get a personalised rate. Prequalification typically doesn’t require a hard credit check, so your credit score shouldn’t be affected.
Keep in mind that your prequalification rates might not be what you end up with — you’ll know your exact rate only after you fully apply. Think of it as a risk-free way of making a more informed decision.
Fees that effective interest rates don’t factor in
It’s tempting to think that effective interest rates cover your total loan cost, but technically there are some other fees that don’t factor in. These fees are circumstantial, so you won’t necessarily have to pay them. They include:
Early settlement fees. Some lenders charge a fee or penalty for repaying your loan early. You could find lenders that don’t charge early settlement fees though.
Late fees. Most lenders charge a fee for paying late — usually S$80.
Nonsufficient funds or returned cheque fees. If you try to make a payment from an account without enough funds, many lenders charge a fee (usually the same amount as the late fee).
You might be able to save with autopay
Setting up automatic payments after taking out a loan has become pretty standard — and for good reason. Not only does it makes payment less of a hassle, but some lenders also knock down your effective interest rate by .25% — and sometimes as high as .50% for signing up.
Bottom line
Understanding personal loan effective interest rates is essential to making a strong comparison. Comparing effective interest rates is the simplest way to tell which loan — with the same terms — is cheapest. Instead of going by the lowest advertised rates, try getting prequalified with a few lenders to see what type of EIR you can expect.
You may. However, expect your interest rates to be on the higher end of the spectrum. Consider looking into taking steps to improve your credit score or getting a personal loan for bad credit.
If you make all of your payments on time you can see your credit score rise. However, you’ll damage your credit if you’re late, default or settle your loan through a debt relief company.
Yes, you may although it could be a confusing process. The general formula to calculate your effective interest rate is: 1 + (nominal interest rate / number of compounding periods)) ^ (number of compounding periods) – 1. This could get messy because different banks offer different definitions for compounding periods and nominal interest rates. Additionally, this calculation doesn’t include extra fees like processing costs. It’s therefore advisable for you to approach your provider with queries related to your effective interest rate.
Yes, this is possible. A payment plan with more frequent repayments often comes with higher effective interest rates.
You can get typically get a low interest rate on your personal loan if you have excellent credit, so taking steps to improve your credit score might be the most effective — but time-consuming — way to get a good interest rate. If you don’t have the time for that, consider looking into a secured personal loan. Check out your other low-interest options here.
Yes, some lenders offer personal loans that can be used to purchase a car. However, you might want to consider taking out an auto loan instead: They’re easier to qualify for, your interest rate might be lower and you might not pay as many fees.
Anna Serio is a trusted loans expert who's published more than 800 articles on Finder to help Americans strengthen their financial literacy. A former editor of a newspaper in Beirut, Anna writes about personal, student, business and car loans. Today, digital publications like CNBC, Business Insider and The Simple Dollar feature her professional commentary, and she earned an Expert Contributor in Finance badge from review site Best Company in 2020.
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