RES exam question on Financing: the approximate Effective Interest Rate on this loan
A bank advertises a personal and renovation loan at a 'flat rate' of 5% per annum over three years, and a borrower who takes $30,000 wants to understand what quoting a flat rate really means for his true cost of borrowing. Which of the following is CLOSEST to the approximate Effective Interest Rate (EIR) on this loan?
- A5.00% per annum
- B7.50% per annum
- C12.00% per annum
- D9.24% per annum
Show answer & explanation
Answer
D. 9.24% per annum
Explanation
A flat-rate loan computes interest on the original principal throughout the loan tenure, even though the outstanding balance reduces with each monthly repayment. Total interest = $30,000 × 5% × 3 = $4,500. Monthly repayment = ($30,000 + $4,500) ÷ 36 = $958.33. Because the borrower repays the principal progressively, the average amount outstanding is roughly half the original loan by mid-tenure. The EIR (also called Annual Percentage Rate) accounts for this reducing balance and the compounding effect, resulting in an EIR approximately double the flat rate — for a 3-year loan, approximately 9.24% p.a. MAS requires lenders to disclose EIR on consumer credit products so borrowers can make genuine comparisons. In property finance, mortgage rates quoted are typically already on a reducing-balance basis, so the quoted rate approximates the EIR more closely — but renovation loans and unsecured credit often use flat rates, making EIR disclosure critical.
Study the concept behind this question: Property Financing in Singapore: LTV, TDSR & MSR
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