When you take a loan, you know the interest rate being charged. It is informed to you upfront before you sign the contract. But is it the real interest rate that you will be paying for the loan?

## Two types of interest rate

### 1. Nominal interest rate

Nominal interest rate is the rate that you see. It is the rate being advertised and written in the contract. Thus, most people will think that this is the interest rate that they are paying.

### 2. Effective interest rate

Effective interest rate is the true interest rate on a loan because it takes into account the effects of compounding. It reflects the true cost of borrowing by taking into account the reducing principal balance over the loan tenure and any upfront processing fee charged.

Hence, effective interest rate may not be the same as nominal interest rate and if different, it will be higher.

## How interest is being charged

### 1. Flat interest

Flat interest is calculated based on the original principal amount of the loan throughout the loan term. Regardless of how much of the principal you have repaid, the interest charged remains the same for each payment period. This means that the total interest paid over the life of the loan remains constant. Flat interest loans often result in a higher total cost of borrowing compared to reducing balance loans, as you are paying the same amount of interest regardless of the decreasing principal balance.

The types of loans that use this method include personal loans and car loans. Let’s say you suddenly receive a lump sum of money, should you settle your loan early? To answer this question, you have to know the Rule of 78.

Under the Rule of 78, a greater portion of the interest is allocated to the early repayment periods of the loan term. This means that borrowers pay a higher proportion of interest upfront, making early repayment more costly. The name “Rule of 78” comes from the sum of the digits representing the number of months in the loan term. For example, for a one-year (12-month) loan, the sum of the digits is 78 (1 + 2 + 3 + … + 12). Each month, a portion of the total interest for the loan is assigned based on the remaining number of months in the loan term. The interest allocated decreases over time, reflecting the decreasing remaining term of the loan. Since more interest is front-loaded with the Rule of 78, lenders could potentially maximize their profits, especially if borrowers repaid loans early.

Thus, you would not get much benefit by settling these loans early.

### 2. Reducing balance method

In reducing balance interest, the interest is calculated based on the outstanding principal amount of the loan. As you make payments, the principal balance decreases, which in turn reduces the amount of interest charged on the remaining balance. This means that over time, the interest portion of your payments decreases, while the principal portion increases. While the interest rate may be higher compared to flat interest loans, the total cost of borrowing tends to be lower due to the decreasing balance.

House mortgage is an example of loans that use this method.

## Conversion from nominal interest rate to effective interest rate

To get the true cost of loans, we must convert the advertised interest rate of loans that charge flat interest.

You could go to this loanstreet website (click here) to do the calculation. The data that you need are total loan amount, the loan tenure, and the interest rate. The calculator will calculate the effective interest rate for you.

## Conclusion

So, the interest rate that you see may not be the true interest rate of your loan. You need to take into account the compounding effect and the effective interest rate is a better measure. A seemingly low interest rate might be not so low after you take into account the compounding effect. As an example, the effective interest rate of a 5-year personal loan with nominal interest rate of 4% p.a. is actually 7.42%! Thus, think twice before you go for a flat interest loan that has an attractive interest rate. It might not be that attractive after all.

One more thing before I end. It is about credit card debt. Although it is using reducing balance method, the interest rate is very high. Furthermore, your balance will keep on ballooning if you do not clear it every month. It is the compounding effect working against you. I think that credit card debt is one of the worst types of loans. Thus, pay off your credit card balance promptly to avoid the interest. Do not carry any balance forward to avoid the exorbitant interest.

## How can a financial planner help you?

If you are thinking of taking on a loan, I could run the numbers for you and see if your cash flow can afford it. Even if you can afford it, we shall see if the total amount payable will make it worthwhile. Furthermore, we can discuss the necessity of taking the loan.

If you have loans, I will make a list of your current debts and devise a debt management plan for you. You should decide whether the snowball method or avalanche method is to be used (click here to learn more about these two methods). As it is your own finances, you are the ultimate decision maker. Even if the plan is perfect, it would not work if you do not implement it. So, let me know your preferences and select a plan that you would implement wholeheartedly.

If you really cannot follow the plan, do not worry and let me know as soon as possible. I will come up with alternatives. Nonetheless, if you always fail to adhere to the plan, perhaps the plan needs to be overhauled. I will help you with this. I will also refer you to the appropriate party to seek help if your situation warrants it.

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*Disclaimer: This post is for informational purpose only. You should* *use judgment and conduct due diligence before taking any action or implementing any plan suggested or recommended in this article.*