Don’t just focus on the advertised interest rate. Understand the different types of loans available and the factors that can affect the interest you ultimately pay.
Key Takeaways
- Loans are not free; you must repay them with interest.
- Generally, loans with longer tenures incur more interest than those with shorter tenures.
- Compare the Effective Interest Rate (EIR) of different loans to get the best deal.
- Always pay attention to the repayment schedule before signing a loan agreement.
Before taking out a loan, be sure to pay attention to the repayment interest. In addition to the interest rate, consider processing fees, legal fees, and other charges that may arise from late or non-payment.
Remember, for the same loan amount, a longer loan tenure will result in more interest paid compared to a shorter one.
Table of Contents
How to Calculate Interest Rates
Not all loans have the same repayment method. Understand the difference between flat rate and monthly rest, and how they affect the calculation of interest.
Flat Rate
With a flat rate, interest is calculated based on the original loan amount itself. The monthly interest remains the same even as your outstanding loan amount decreases over time.
Flat rates typically apply to car loans and personal term loans.
Car Loans
Here is an example calculation for a $90,000 car loan at a fixed rate of 2.5% per annum. Note that a seven-year loan will generate more interest than a five-year loan.
| Repayment | Five-Year Loan | Seven-Year Loan |
| Monthly Repayment | $1,687.50 | $1,258.93 |
| Total Repayment | $101,250 | $105,750.12 |
| Total Interest Paid | $11,250 | $15,750 |
Monthly Rest
For a monthly rest rate loan, the monthly interest is calculated based on the outstanding principal from the previous month. As you pay down the remaining principal each month, the interest also decreases over time.
Monthly rest rates typically apply to home loans.
Monthly Rest Loan
Assuming your loan amount is $600,000 with a 20-year tenure and a fixed interest rate of 3.5% per annum, you would need to make a monthly repayment of $3,480 over 240 months.
Below is your repayment schedule for the first five years. Notice how the interest portion of the repayment amount decreases over time.
| Year of Repayment | Interest Rate | Monthly Principal Repayment (A) | Monthly Interest Repayment (B) | Monthly Repayment Amount (A+B) | Annual Repayment Amount |
| 1 | 3.50% | $1,729.76 | $1,750.00 | $3,480 | $41,757 |
| 2 | 3.50% | $1,791.28 | $1,688.48 | $3,480 | $41,757 |
| 3 | 3.50% | $1,854.99 | $1,624.77 | $3,480 | $41,757 |
| 4 | 3.50% | $1,920.97 | $1,558.79 | $3,480 | $41,757 |
| 5 | 3.50% | $1,989.29 | $1,490.47 | $3,480 | $41,757 |
Fixed Rate vs. Floating Rate
For a monthly rest loan with a fixed rate, the interest rate will remain unchanged for a period of time, known as the “lock-in period.”
A floating rate means the interest rate can move up or down. If the rate increases, your interest payments will be higher. Be sure to consider this when deciding if you can afford the loan.
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Effective Interest Rate – The True Cost of Your Loan
The true cost of a loan is called the Effective Interest Rate (EIR). Due to the different ways interest is calculated, the EIR may be higher than the advertised interest rate.
• For a flat rate loan, the EIR is higher than its advertised rate because interest is calculated on the original principal amount at the same rate (the advertised rate) throughout the entire installment period.
• For a monthly rest loan, the advertised rate is the same as the EIR because the interest decreases as the principal is reduced.
Furthermore, note that the frequency of payments can also affect the EIR. Consider two loans with the same principal, interest, and tenure. The loan with smaller installment amounts and more frequent payments will cost more than the loan with fewer installments and larger repayment amounts.
Example: How Payment Frequency Affects EIR
For a $1,000 loan with a one-year tenure and $200 in interest, the EIR will vary based on the repayment schedule:
| Repayment Schedule | Effective Interest Rate (EIR) |
| Lump-sum repayment of $1,200 after one year | 20.0% |
| 2 repayments of $600 every 6 months | 27.8% |
| 4 repayments of $300 every 3 months | 34.6% |
| 6 repayments of $200 every 2 months | 37.7% |
| 12 repayments of $100 every month | 41.3% |
Comparing Different Loan Packages
Ask your bank for both the advertised interest rate and the EIR of the loan. You can use the EIR to compare different loan packages to find the one with the lowest cost.
The higher the EIR, the more interest you will pay.
However, you might not always want to choose the loan with the lowest EIR. For instance, if you plan to repay the loan early, you might opt for a loan with a higher EIR, provided there are no penalties for early repayment.
Deciding on a Repayment Schedule
Besides interest, you also need to consider your ability to make monthly repayments when choosing a loan tenure.
Generally, a shorter loan tenure means lower overall interest but higher monthly repayments (and vice versa). Can you consistently make the repayments throughout the entire loan period?
To help you decide, ask your bank for a repayment schedule. It can help you understand the total cost of the loan (including the total interest payable).
Note
If you choose a floating rate loan, remember that interest rates can rise. Even a small increase in the rate can have a significant impact on the total amount you pay, so plan accordingly.
Other Costs of a Loan
A loan may come with other costs, such as various service fees, processing fees, and third-party costs, which can add up. You may need to factor these in when calculating the cost of your loan.
| Service and Processing Fees | What it’s for |
| Processing fee | To process the loan application (usually charged upfront upon loan approval) |
| Amendment fee | To change the original loan application |
| Cancellation fee | For not accepting or drawing down the loan after it has been disbursed |
| Excess fee | For withdrawing an amount exceeding the original overdraft limit |
| Late payment fee | For not making the full repayment by the due date |
| Default fee | For non-payment |
| Early repayment fee | For repaying part or all of the loan early |
Note: Your bank can change the terms and conditions, including interest rates, service fees, and processing fees, with prior notice.
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