Definition: In the context of loan, it is a rate which is charged or paid for the use of money. An interest rate is usually expressed as an annual percentage of the principal amount. It is calculated by dividing the amount of interest by the amount of principal.
There are various types of interest rate in finance, however, in this topic we will only look at the effect of interest rate on loans resulting in debts. Understand Interest rate, allows one to assess the cost of borrow and if it’s a debt worth committing in order to leverage on loan as a good debt.
Simple Interest / Nominal Interest Rate
A simple method of calculating the interest charge on a loan is simple interest. It is determined by multiplying the interest rate by the principal by the number of periods.
Simple Interest = P x I x N
Assuming:
- P is the loan amount = $1,000
- I is the interest rate = 20% per annum
- N is the duration of the loan, using number of periods = 60 months / 5 years
- Simple Interest = $1,000 x 20% x (60/12) = $1,000
As you can see, if the cost of borrowing is as such, we are actually paying 100% of the principal amount over 5 years.
Nominal Interest Rate
Its an interest rate indicated by the lender / Issuer before considering the inflation rate. The above example on simple interest can be considered a Nominal interest rate.
Real Interest Rate
If you have understood Inflation Rate, The Real Interest rate has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower, and the real yield to the lender. The real interest rate of an investment is calculated as the amount by which the nominal interest rate is higher than the inflation rate.Real Interest Rate = Nominal Interest Rate – Inflation Rate (Projected or Actual)
Assuming:
- Nominal Interest Rate = 0.05% interest per year on a typical savings account in Singapore.
- Inflation Rate = 4% per year based on recent reading.
- Real Interest Rate = 0.05% – 4% = -3.95%
From the above example, the real value of your savings is actually decreasing by 3.95% per year, If you still thinks putting your money in a saving account in a bank is to build your wealth is correct, please reconsider other financial tools to at least fight against our ever increasing inflation rate.
Effective Interest Rate
The Effective Interest Rate, Annual Effective Rate / Annual Percentage Rate (AER/APR) or simply effective rate takes into account the fact that you are NOT borrowing the entire principal for the entire loan. For each repayment the interest is tabulated with the progressively decreased principal.
As the loan capital is repaid throughout the life of the loan, the interest charged per month declines accordingly.
APRs automatically mean the rate is charged on any outstanding debt.
For an examples, if you were to borrow $5,000 over 5 years, with annual repayment of $1,000 and by the last year you only pay interest on the amount remaining, say $1,000. At 6% APR the total interest is $800.
Flat Interest Rate
It’s the same interest rate is fixed throughout the period for the total loan amount. A flat rate calculation presumes the whole principal is borrowed for the entire loan period, regardless if you have made any repayment during your loan tenure.
With a flat rate the interest is charged on the original amount borrowed, no matter what’s been repaid.
So for an example, if you were to borrow $5,000 over 5 years, with annual repayment of $1,000 and by the last year you will still be paying an interest on the SAME loan amount of $5,000. At 6% flat rate, the total interest is $1,500.
Now, do you know which most banks usually use flat interest rates especially for Auto Loans. Compare it yourself with a simple loan calculator and a auto loan calculator, you will see a $2,400 interest compared to a $7,000 interest respectively.
- Loan amount: $50,000
- Interest Rate: $1.88% / 2.88%
- Loan term: 5 years or 60 months