A loan consists of 3 main components: the principal amount, the interest rate and the number of months for repayment. There are many types of interest rate calculations. The two most common types are simple interest rate and effective interest rate.
SIMPLE INTEREST RATE
As the name suggests, simple interest rate is meant to be intuitive and easy to understand. Hence it is the interest rate of choice at Funding Societies, so that everyone knows the actual returns they can expect from each loan.
Simple interest rate per year = Interest / Principal / Repayment Months * 12
For a 6-month loan of S$ 100,000 repaid monthly, with total interests of S$ 5,000
Simple interest rate per year = S$ 5,000/ S$ 100,000/ 6 * 12 = 10%
EFFECTIVE INTEREST RATE
Effective interest rate calculates the returns as if the monthly repayment is reinvested at the same rate till the end of the tenor. It takes into account compounding effect and the frequency of instalments over the period.
There is no “simple formula”, but it can be calculated using the RATE function in Excel.
RATE (nper, pmt, pv, [fv], [type], [guess])
- Nper : Number of payment periods
- Pmt : Payment made each period, includes principal and interest but not fees
- Pv : The present value that a series of future payments is worth now
- Fv : The future value that you attain after the last payment is made