How Does Interest Rate Work on a Loan and How to Calculate It (Free Loan Calculator Inside)

Before taking up a loan, it is important to understand the loan terms–especially the interest rates–which determine how much you need to repay,

How does interest work on a loan? Some loans charge a flat interest rate while some are reducing interest rates. How does a loan calculator reducing balance formula work?

Here, we share all you need to know about loan interest rates so you can make the right decision before taking up a loan.

What are the different kinds of loans you can take?

1. Car loan: Also known as an auto loan, a car loan is a loan that helps you to pay for the cost of your car, up to 60-70% of the total car price.
2. Housing loan: Also called a home loan or mortgage loan, a housing loan is meant to help you pay for property purchases.
3. Personal loan: One of the most flexible loans, a personal loan can be used for any and every situation you can think of.
4. Bridging loan: A bridging loan is a short term loan used for paying the downpayment of your new property purchase while you await the sale proceeds from your existing property.
5. Renovation loan: A renovation loan can only be used to pay for renovation works. It cannot be used to purchase things like furniture, fittings, curtains, mattresses, and household appliances.
6. Business loan: A business loan can be used for a variety of purposes, such as scaling up business operations, buying equipment, managing cash flow issues, etc.
7. Study loan: Also known as an education loan or student loan, a study loan is used to pay for the cost of ​​a student’s tertiary education.

What are the interest rates of different types of loans?

Here are the various interest rates offered by different financial institutions for different types of loans:

What is the difference between annual interest rates and effective interest rates?

Do note that the annual (advertised) interest rates and effective interest rates aren’t the same.

The annual interest rates are the interest rates that banks, financial institutions, and licensed money lenders advertise. On the other hand, effective interest rates (EIRs) factor in other costs like administrative fees, processing fees, and transaction fees. This is why the EIRs are almost always much higher than the annual interest rates.

Long story short, pay attention to the EIR when shopping around for a loan.

How does interest work on a loan?

Understanding how a loan is calculated can be tricky as some loans use a flat interest rate while others use a reducing rate. Fret not, you can work your sum using a loan calculator reducing balance formula.

Loan Calculator: how to use the reducing balance formula?

This method calculates interest payments on the outstanding principal balance instead of charging a fixed flat interest based on your original loan amount.

This means that as you pay off your loan gradually, your outstanding loan amount reduces and the interest you need to pay reduces as well.

Reducing Loans: important things to take note

When it comes to loans in Singapore, there are three types of reducing loans you need to know: (i) daily-, (ii) monthly-, and (iii) annually-reducing loans.

EMI refers to equated monthly instalments (i.e. fixed payments for paying off the loan in full over the loan tenure).

Repayments for reducing loans are made in equated monthly instalments based on the following formula:

EMI = p *((r *(1+r)^n))/((1+r)^n-1)), where:

• p = principal amount borrowed,
• r = monthly interest rate, and
• n= total number of monthly payments

Calculation

Example 1: Ben borrows $200,000 at an interest rate of 3.5% for 10 years.

Flat rate method

EMI = $200,000 + ($200,000*10*0.035))/ (10*12) = $2,250

Reducing balance method (monthly)

EMI = $200,000*((0.0029*(1+0.0029)^120)/ ((1+0.0029)^120-1)) = $1,978

From the two calculation methods shown above, you can see that the reducing balance method is the more cost-effective option. If your loan is calculated based on the flat rate method, you may wind up paying more interest in the long run.

Example 2: Here’s a $6,000 loan with a 7% interest rate over a 12-month tenure, calculated using the flat rate method and a monthly-reducing balance method.

Reduced balance calculation (using a loan calculator reducing balance formula):

Total reduced rate interest: $229.93

Flat rate calculation:

Total flat rate interest: $ 420.00

From the two tables above, we can see that with a reduced rate calculation, you pay less interest in total.

Loan Calculator

Don’t worry if all these calculations seem daunting. Fret not, use our free loan calculator to easily work out the interest amount on your loan.

Why is it important to use a loan calculator before you take up a loan?

Using a loan calculator gives you a better idea of the amount of interest you are expected to pay, depending on how interest is being calculated on the loan you are taking, and how much you need to repay with each repayment.

This will help you with your monthly budgeting, so you can plan how much to set aside each month for your loan repayment. Plus, it helps you assess if you are able to repay your loan on time.

Late fees and interest charges apply if you repay your loan late, so it’s important to check if your repayment schedule and repayment amounts are still manageable.

Why take a loan with a licensed money lender?

If you are looking for short-term loans or urgent loans (up to 12 months), licensed money lenders in Singapore are your best bet, as they have less stringent credit checks and offer faster approvals.