Contributed by Mr Gunasegaran Munusamy of AKPK
Having a loan, credit card or an investment necessitates interest. Whether one pays or receives it, it is wise to be aware of the existence of effective interest rate (EIR) on one’s borrowings or investments.
An EIR — also known as an effective annual interest rate, annual equivalent rate or simply, effective rate — is the interest rate on a loan or financial product which is restated from the nominal interest rate to the interest rate with annual compound interest. The EIR is used to make loans with different compounding terms more comparable, be it on a daily, monthly or annual basis.
The EIR of an investment or loan will always be higher than the nominal or stated rate. As the number of compounding period increases, so will the difference between the nominal and effective rates.
To convert a nominal rate to an equivalent effective rate, apply this formula:
Where: i = Nominal Rate, and n = Compounding Period
It will help to make a fair comparison between two interest rates when different compounding periods are used. First, convert both nominal (stated) rates to their equivalent effective rates so that effects of compounding can be clearly seen.
So how do we apply this?
Example:
a. If you invest RM1,000 and are promised to be paid a 6% monthly compounding interest, how much will it be after one year?
- EIR for 6% is 6.17% based on the above formula
- So, the amount after a year = 1,000 x 1.0617 = 1,061.70
b. If you intend to save, one bank may offer you 6% interest with a half yearly compounding rate, while another bank offers 5.95% with a monthly compounding rate. Which will result in better returns after one year?
- You will need to convert the nominal rates to EIR and then compare the two
- We find that EIR for the 6% half yearly compounding is 6.09%, while EIR for the 5.95% for monthly compounding is equivalent to 6.11%
This goes to show that even if the nominal rate of 5.95% (compounding monthly) is lower than 6% (compounded half yearly), it will result in better returns after a year. Thus, one must compare the EIR offered between loans or investment to make smart decisions.
The examples above represent you lending money to the bank. When it comes to credit card debt, you must remember that you are borrowing money from the bank and your payment to your credit card is due on a monthly basis. Basically, the quoted interest rate on your credit card balance is always higher because of the compounding effect.
Therefore, in applying for a credit card, car loan or an unsecured personal loan, always ask what is the effective interest rate from your lender. Otherwise, with the formula given above, you can always make comparisons between different financial products by making your own calculation.