Costs of borrowing: Flat rate, monthly rest, and Effective Interest Rate

Before taking out a loan, think about the interest payments. Apart from the interest rate, consider the processing fees, legal costs and other charges due to late or non-payment.

Remember, for the same amount borrowed, you pay more interest for a longer loan period than for a shorter loan period.

How interest rates are calculated

Not all loans work the same way. Learn about flat and monthly rest rates, and how they affect interest calculations.

Flat rate

With a flat rate, interest payments are calculated based on the original loan amount. The monthly interest stays the same throughout, even though your outstanding loan reduces over time.

A flat rate is commonly used for car loans and personal term loans.

Car loan

Below is a calculation for a $90,000 car loan at 2.5% interest per annum flat rate. Notice that you will end up paying more interest for a 7-year loan than for a 5-year loan.

Monthly rest rate

With monthly rest, interest is calculated based on the outstanding balance of the loan. As you pay down your outstanding loan amount every month, the interest also reduces over time.

Monthly Rest Rate is commonly used for home loans.

Loan on monthly rest

Say you have a $600,000 loan payable over 20 years at a fixed rate of 3.5% per annum and you have to make 240 equal monthly repayments of $3,480.

Here's what your payment schedule might look like for the first five years. Notice that the interest portion of the payment reduces as time goes on.

Fixed versus floating rate

For a fixed rate monthly rest, the interest rate stays the same for a period of time known as the lock-in period.

For a floating rate, the interest rate can move up or down. If interest rate moves up, your interest expense will be higher. Do factor this in when deciding if you can afford a loan.

Effective Interest Rate - What your loan actually costs

The true cost of your loan is known as the Effective Interest Rate (EIR) which may be higher than the advertised rate because of the way interest is calculated.

• For flat rate loans, the EIR is higher than the advertised rate because the same rate (advertised rate) is applied throughout the loan period, based on the original loan amount.

• For monthly rest loans, the advertised rate is the same as the EIR, because interest is calculated based on the reduced balance of the loan.

Also, note that that the frequency of payments may also affect the EIR. Think about two loans with the same principal amount, interest and duration. The loan with smaller, more frequent instalments will be more costly than one with fewer but larger instalments.

For a $1,000 loan, repayable over a year with interest of $200, the EIR will vary depending on the repayment schedule:

Comparing loans

Ask your bank for the advertised and effective interest rates. You can use EIR to compare different loan packages to find out which one costs the least.

The higher the EIR, the more interest you will be paying.

However, you may not always want to choose the loan with the lowest EIR. For instance, if you intend to repay early, you may take a loan with a higher EIR, but without any early repayment penalty.

Deciding on a repayment plan

Apart from the interest, you will also need to consider your ability to meet the monthly repayment when choosing the loan tenure.

Generally, a shorter loan tenure means less interest overall but a higher monthly repayment (and vice versa). Are you able to keep up the payments for the entire loan period?

To help you decide, ask your bank for a repayment schedule. It will give you an idea of the total borrowing costs (including the total interest payable).

Note: If you take up a floating-rate loan, keep in mind that interest rates can go up. Even small increases can make a big difference in the total amount you pay, so plan accordingly.

Other costs of loans

Loans may come with other costs such as fees, charges and third-party costs, which could add up. You may need to factor these into your calculations.