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Learn > Sens ability > Effective Interest Rates (EIR)

Effective Interest Rates (EIR)


All of us know what interest rates are. For savings, the interest rate is how much the bank pays you for putting your money into a savings account. For loans, the interest rate is how much the bank charges you for the money you borrow from it.

But different loans actually have different types of interest rates that calculate your interest payments differently. For example, a flat annual interest rate of 2% isn’t the same as a reducing balance interest rate (What’s that? Find out more below) of 2%.

So for a consistent comparison of the cost of a loan, always look for its Effective Interest Rate (EIR) or Effective Profit Rate (for Syariah-compliant loans).

Guide
 
 

Infographic

THINGS TO KNOW
 
 

Flat interest rate and reducing balance rate

There are generally two types of interest rates – a flat interest rate (not to be confused with a fixed interest rate) and a reducing balance interest rate.

Flat interest rate

A flat interest rate is calculated based on the original amount you borrow (or principal).

For example, if you take a 5-year loan for RM1,000 at a flat interest rate of 4% per annum, you will be paying an interest of RM40 (i.e. 4% of RM1,000) every year for 5 years. In total, you will have paid RM200 in interest payments.

As a result, the total interest you need to pay remains the same no matter how much of the principal you repay.

Your EIR here is 7.42% (compared to the given flat interest rate of 4%).

This interest rate method is used for personal loans and vehicle/hire purchase loans.

Reducing balance interest rate

A reducing balance interest rate, on the other hand, is calculated based on your outstanding or leftover  loan balance, which is the amount you originally borrowed (the principal) minus the amount you’ve already paid off.

For example,  you take a 5-year loan for RM1,000 at a reducing balance interest rate of 4% per annum and make monthly payments. You’ll be paying off a bit of your principal each month, so the amount of interest you pay will also go down. In total (after the 5 years), you’ll have paid RM105 in interest payments.

Notice how this RM105 is about half of the RM200 interest for a flat interest rate loan of 4% per annum.

Your EIR here is 4% (same as the given reducing balance rate of 4%).

This interest rate method is most commonly used for home loans.

 
 

Conversion of a flat interest rate to an Effective Interest Rate (EIR)

We won’t bore you with the formula to convert a flat interest rate to an EIR, but basically, the EIR for a flat rate is actually about 2 times the advertised flat interest rate.

If you’d like a rough estimate of the EIR for a flat interest rate loan, you can just multiply it by 2. So a flat rate of 3% per annum would have an EIR of about 6% per annum.

How’s this important? Say you’re trying to decide between getting a credit card and a personal loan. You can compare their EIRs to see which one is actually better.

For example, if the personal loan interest advertised is 12% per annum, this means the EIR is about 24%! If a credit card’s EIR is 18%, you’ll see the credit card might actually be the better option. Since a credit card’s interest reduces as you pay the balance off (it’s a reducing balance interest after all), you might end up paying even less than 18% in interest if you pay off the whole amount within 1 year.

For a more accurate calculation, use our EIR calculator.

 
 

Practical advice

  • Where can I find the Effective Interest Rate of a loan?

You’ll find it in the fine print of the Product Disclosure Sheet (PDS), or somewhere on the loan webpage. Sometimes it may be difficult to find or even not displayed anywhere. If this is the case, call the loan provider and ask for it!

  • How can I minimise the overall cost of my loan?

    • Flat interest rate loans

For a flat interest rate, once you agree on a loan period (e.g. 3, 5, 6 years), you will need to pay the interest for the full loan period. Even if you end up repaying the loan in full earlier!

On top of that, you may also have to pay a penalty fee for making an early payment.

To save on the cost of a loan with a flat interest rate (e.g. vehicle, hire purchase or personal loan), try to get one for a shorter period but with a monthly repayment rate that you can still afford. And then make your monthly repayments on time to avoid early or late repayment penalties.

    • Reducing balance interest rate loans

For reducing balance interest rate loans, you can save on your interest payments by making early repayments. If you happen to have some additional spare money, you could make a one-off repayment for the loan and bring down the principal amount further. This would reduce the interest you pay.

Calculator

Use this calculator to calculate the effective interest rate of the loan based on the advertised interest rate of the loan.

Quiz: Flat vs Effective Interest Rates

Source: MULTIPLY | Published: December 2020

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