Understanding banking terms and how loans work?
When you apply for a loan, many financial terminologies can sound confusing. Here are some important bank loan terms to know.| Principal/Loan amount - the amount you borrow Interest - what you pay the bank to borrow money and it is based on the agreed interest rate Interest rate - the annual percentage rate (APR) that the bank charges for the loan Loan period/Tenure - the number of months/years for you to pay back the loan Repayment schedule - Instalment - the monthly amount that you need to repay to the bank Effective interest rate (EIR) - the total loan cost percentage Fees - other costs of taking out a loan, such as origination fees, late fees, insufficient funds fees and more |
How does loan repayment work?
When you borrow money from the bank, you need to repay the amount you borrowed, and the interest charged for the loan. Every month you repay the bank the agreed amount based on the repayment schedule calculated by the bank.How is loan interest calculated, banks use these three methods
There are three methods that banks use to calculate loan interest charges. One is the flat-rate method, commonly used for calculating shorter-term loans such as car and personal loans. The second is the amortisation method (also known as reducing/diminishing balance) for longer-term loans such as housing loans. And the third, to make loans more affordable, banks offer interest-only loans that only require repayment of interest charges in the first years.Same principal amount but a different cost of borrowing
The method used to calculate the loan interest charges decides the cost of your borrowing. Flat-rate method loans are the most expensive while amortised loans are the cheapest of the three. So, before you sign up for a loan, check with the bank which method is used to calculate the loan you want to take up.The total cost of your loan is different from the interest rate that you pay
When applying for a loan, most people only focus on the interest rate that the bank charges and the monthly instalment they need to pay. Few people know how loan interest charges are calculated and the actual cost of their loans. The actual cost of loans is the loan’s Effective Interest Rate (EIR). The EIR is the percentage of total interest charges and fees paid for the loan. Knowing the loan’s EIR is the most important thing for borrowers because EIR measures: -- The feasibility of the loan. For example, a $500,000 property financed using a 30-year loan with an interest rate of 5% pa, calculated using the amortisation method will cost you interest charges of $466,000. This translates into an EIR of 93.2% of the principal loan amount (we have not added the loan fees yet). What it means is that when you finish repaying the loan in 30 years, your property will cost $966,000.
- The cost of the loan. It is a useful tool when comparing loans offered by the various banks. When shopping for a loan, it can be confusing when banks offer different interest rates, tenures, and fees for loans. But with the EIR as a benchmark, you can easily compare the costs of the loan products in the market and not just decide based on the interest rate offered.
