Microfinance organizations do not have indulgence to indicate effective interest rates in loan agreement and, therefore, while comparing loan product prices of the bank and microfinance organization pay extra attention to other expenses in microfinance. While comparing interest rates in microfinance organizations compare not only nominal interest rate, but also monthly payables. In case you take a loan in USD pay attention to two effective interest rates, which will be indicated in loan agreement. First effective interest rate includes calculations re national currency exchange rate and the other effective rate includes additional expenses related to 15% annual devaluation of the national currency.
Consumer loan is smaller, than mortgage loan. Besides that, it has less maturity. Mortgage loans generally are applied to buy real estate, for renovation, etc. In case of taking mortgage loan it’s necessary to have immovable property, which will be used by the bank as collateral. No collateral is required for consumer loan, as a rule.
In case you apply for a loan, you should pay attention to the following expenses: nominal interest rate, loan approval commission, Insurance commission (if any), Fee for administrative services (charges related to mortgage registration and cancellation), life insurance, etc. to calculated total expenses.
Example 1: Bank #1 has nominal interest rate as 20%, effective interest rate as 22%, contract maturity 12 months; Bank #2 declared nominal interest rate as 20% and effective interest rate as 26%, contract maturity 12 months. Which bank offers a cheaper loan? Correct answer is bank #1, because effective interest rate is lower. This means that the client has less financial expenses in bank #1 (pays less fees, doesn’t have to pay insurance fee or any other expenses).
Example 2: Bank #1 offers loan with nominal interest rate as 20% and effective – 22%, contract maturity 12 months. Bank #2 has nominal rate as 18% and effective as 22%, with same maturity. Which bank offers a cheaper loan? Both banks have equal proposals, as the client will have same expenses. Nominal interest rate is different, but overall expenses are the same.
Example 3: One of the banks offers nominal interest rate as 20% and effective as 22% (which includes loan approval commission of 1%). Loan term is 12 months. One of the microfinance organizations offer nominal interest rate as 18%, loan approval commission is 3% and insurance fee 2%, with 12 months term. Who offers cheaper loan? In the example the bank offers a cheaper loan. Despite the fact, that nominal interest rate was lower in microfinance organization, this institution has more expenses related to loan disbursement (approval commission, insurance commission, etc.), which makes loan more expensive for the client.
Nominal interest rate is indicated in loan agreement and reflects interest rate, which is added to initial loan amount. But it does not include other financial expenses (like loan approval fee, insurance commissions, etc.), while Effective interest rate reflects all expenses related to loan taking process taking into consideration the maturity of the contract. Expenses include nominal interest rate as well as loan approval and insurance commission, life insurance commission and so on.
Effective interest rate reflects all expenses related to loan receipt process taking into consideration the maturity of the contract. By knowing effective interest rate you have a fair opportunity to compare loan terms of different financial institutions and take the best decision for you.
Nominal interest rate is indicated in loan agreement and reflects interest rate, which is added to initial loan amount. But it does not include other financial expenses (like loan approval fee, insurance commission, etc.).