The cost of debt: Your interest charges should interest you
If you don’t have time to read through the whole article, you can check out our short version below:
Understanding the different types of interest charges:
There are different types of interest charges, such as Effective Interest Rate (EIR) and per annum (p.a.) interest rate.
Interest can be calculated using the “flat rate” or “reducing principal” method.
Try to repay your debts in full and on time to avoid adding to costs.
There is no definitive classification of “good” or “bad” debt. Whether to take a loan or charge to a credit card—and what type—depends on your needs and circumstances, which will vary from individual to individual. Your friend might need a personal loan to tide his family over a medical emergency, while you may use a credit card to pay for your child's overseas immersion programme. Most of us would need a loan for big-ticket purchases, such as a house or car.
But borrowing comes at a cost—which includes not only interest charges, but also other charges such as processing and administration fees. We delve into how the costs of debt can stack up.
Most banks and other lenders would publish “advertised interest rates”, also known as the “nominal rate” or the “% p.a. headline” rate, which tend to be lower than the Effective Interest Rate (EIR). It is important to be able to use this information to calculate the real cost of different types of debt, from personal loans to credit cards.
The rate you want to focus on is the EIR, which reflects the true cost of borrowing. It takes into account:
- Processing, administration, and other fees that are incurred when you take up the loan. These fees are added to the interest charged on your loan, which increases the total amount you have to repay.
- The effect of compounding: It considers the loan tenure, repayment (or instalment) frequency, and each instalment amount.
Generally, a longer loan tenure—with a lower monthly instalment—comes with a lower EIR. But over a longer term, you will chalk up more interest overall.
Let’s say Ben, Jerry, and Hershey each take a S$10,000 personal loan with different tenures, which in turn affect their instalment amounts. All else being equal, here’s how their EIRs would compare:
Source: DBS Personal Loan Calculator
Note: Calculations are for illustrative purposes only. Interest rates and amounts may differ, depending on the loan structure and provider.
A related issue is whether you are paying interest based on original principal or reducing principal. As a borrower, aim to go for a “reducing principal” loan, as interest charges tend to be lower.
In the “flat rate” method, interest is calculated on your original amount borrowed, and remains the same throughout, even though your outstanding loan declines as you gradually repay it. Types of loans that use this method of calculation include car loans and personal loans.
In the “reducing principal” method, interest is charged based on your loan’s remaining balance, which gradually falls as you pay it off. Types of loans that use this calculation method include mortgage loans.
All forms of debt come at a cost. But while that may not stop you from taking a loan necessary for your situation, here are two possible ways to help you trim interest costs:
Consider a shorter loan tenure.
A shorter tenure generally means higher repayments, but lesser interest paid over time. However, check if you are able to commit to the repayment amounts consistently, as late payments may also result in charges.
Make repayments more often, so that you can clear your debts faster.
This works especially for loans based on the “reducing principal” interest calculation.
Ultimately, how much to borrow, what to borrow for, and how much to repay depends on your cash flow. Ensure that you have sufficient cash to repay all your debts—ideally in full and on time to avoid adding to your cost of debt.
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