Effective Returns and Effective Interest Rates de-mystified

[Dennis Ng]

As you might know, I speak on the Radio Financial Planning Talkshow on Capital Radio 95.8 FM every TUESDAY

11.15 am to 12 pm. The program is further extended to incorporate a special ?Q & A? session that listeners call in after the program ended on 12 pm where we will then ?broadcast? their questions and my reply later on the same day between 3 pm to 4 pm.

This additional segment is introduced as many listeners in the past called in but couldn?t get through The line.

Attached below is a summary of the discussion on 24 Aug 2004.

Topics discussed:

1. difference between total returns and annual returns
2. difference between simple annual returns and compounded annual returns.
3. what?s returns calculated on ?bid-to-bid? basis?
difference between ?monthly rest? and ?daily rest? for housing loan calculations.
4. difference between ?housing loan interest calculation? and ?car loan interest calculation?
5. do you know that for car loan your interest is ?calculated upfront? on ?flat rate basis?? This means any pre-repayment or refinancing of CAR Loan is to your disadvantage!

Cheers!


Dennis Ng, 9852 0663

www.LeverageHoldings.com - Financing Made Easy

DJ I-Ling: last week during the Q & A session someone asked what is effective rate of returns..do you know there?re various ways of calculating returns and interest rates? Do you know that the way they calculate interest for car loans is totally different from that of housing loans? Today, we have invited Dennis Ng, Wu Jia Wan, a Certified Financial Planner to share with us again?.


DJ I-Ling: last week you mentioned about difference between total returns and annual returns, can you repeat again so that it?s clearer for our listeners?


Dennis: sure. Let me quote an example to explain more clearly. Like I mentioned, recently I saw a brochure saying 22% returns?.on reading further, then you realise that 22% is the total returns you get over 8 years?..so to get a simple annual returns, you just use total returns of 22% divided by the number of years, here 8 years, which you get 2.75%....


DJ I-Ling: you mentioned this is a simple annual returns?.what?s the difference between a simple annual returns and ?compounded? annual returns?


Dennis: in simple returns, the annual interest or returns you get is not added on to the principal?in compounded returns, it take into consideration the adding on of interest to your original principal?.so as time goes by, your savings grow as interest is added on to your principal and next year?s interest is calculated on original principal plus last year?s interest.


DJ I-Ling: can you use an example to illustrate?


Dennis: sure. For instance, if your principal amount is $10,000. If you get interest of 2%, one year you will get interest of $200. At end of year 1, this $200 interest is added on to your principal, and your money grows to $10,200. In year 2, your interest is based on principal of $10,200, not $10,000, thus the interest you get is $204, not $200?so if we use annual compounded returns instead, the 8 year plan to pays 2.75% simple annual returns only give a compounded returns of 2.68%.


So in this case, the annual compounded returns is also said to be the annual effective returns. For a short time period of say 1 year, the difference between simple annual returns and compounded returns in this example is only 2%.....however, given time, eg. if this is repeated 20 years?using this same example of $10,000 and 2% interest rate, the difference in total returns is 21.45%!


DJ I-Ling: sometimes we also read that the returns is calculated on a bid-to-bid basis? What does that mean?


Dennis: returns on bid-to-bid basis relates to investments in unit trust. As you know, for unit trust prices there?s ?bid? price (the price you get back when you sell) and the ?offer? price (the price you pay when you invest)?.typically, the difference between these 2 prices is about 5%... so eg. if a fund offer price is $1. Its bid price is 5% less or 95 cents. As different investor may invest into a fund at different prices?eg 1 at $1, another at $1.50, and another maybe even higher at $2?..so in order to show a fund performance, they just use the bid price to calculate.


DJ I-Ling: can you show us an example?


Dennis: sure. Eg a fund is launched at $1. 3 years later, the bid price went up to say $1.20. Both $1 and $1.20 are offer price, the price you invest. The bid price when offer price is $1.20 is actually $1.14. So they can announce the 3 years total return for the fund on a bid to bid basis is $1.14 less $0.95 or 19% returns?however, if you invested when price is $1. Your actual total returns based on offer-bid price is only 14%, not 19% or 5% less. So in order to calculate your actual total returns, you need to know the price you bought the fund when you invested?..looking at bid to bid price may not be reflective of your actual situation.


DJ I-Ling: in above case, what?s the annual simple returns and annual compounded returns?


Dennis: In above case: annual simple returns is total returns of 19% divided by 3 years or 6.33%....while the annual compounded returns is only 6.26% lower than the annual simple returns?


DJ I-Ling: What you have shared so far is on returns we get when we invest. What about when we borrow? What are the different ways of calculating interest for eg. housing loan?


Dennis: For housing loan, typically, there?re 2 ways of calculating interest, one is known as monthly rest and one is known as daily rest.


For housing loan you repay every month. So in monthly rest calculation, after each monthly payment, the interest on your loan is recalculated once every month. For daily rest basis, even though you repay every month, not everyday. However, the interest on your loan is recalculated everyday instead of once a month?.thus, housing loan using daily rest basis the total interest will be slightly lower than that calculated under monthly rest basis.


DJ I-Ling: can you show us an example?


Dennis: sure. If you borrow $200,000 housing loan for 30 years. Assuming if interest rate is 2.6%. Under daily rest, your total interest payable over 30 years is $88,244.59. While under monthly rest, your total interest payable over 30 years is $89,183.29 or the difference is about $1,000.


DJ I-Ling: so that?s how interest on housing loan is calculated. What about for car loan? Is the interest calculated the same way?


Dennis: no, for car loans, it is calculated in a very different way. It?s calculated on a ?flat rate? basis and the annual effective interest rate is much higher than what?s quoted on a flat rate basis.


DJ I-Ling: how exactly do they calculate interest on a flat rate basis. Can you show us an example?


Dennis: definitely. For instance, if you borrow $50,000 for a car loan and repayment period is 7 years and the interest rate quoted is 2.2%. The way they calculate interest is using your loan amount $50,000 x the interest 2.2% and x by the number of years, here 7 years. Thus, total interest = $7,700.


Thus, at end of 7 years, you would have paid principal of $50,000 and interest of $7,700. The total you paid is $57,700. So they calculate your monthly instalment by dividing this total amount of $57,700 by number of months, which is 84 months and in this example, the monthly instalment is $687.


DJ I-Ling: so unlike housing loan, the interest you pay is calculated on the original loan amount and not reduced as your monthly repayment reduce the principal?


Dennis: yes, that?s the main difference. Car loans are calculated on flat rate basis. This means the lender charges interest on the full loan for the entire loan period, without taking into account the progressive reduction of the loan through monthly repayment. So in fact, the effective interest rate on car loan is not 2.2% as quoted but much higher. In this example, the effective interest rate is actually 4.15%, almost double!


DJ I-Ling: nowadays, car loan can be repaid over as long as 10 years instead of 7 years. So in the above example, if the loan repayment period is 10 years, would the interest be even higher?


Dennis: yes, as mentioned, becos for car loan, the interest charged is based on the entire loan amount for the entire loan period. Thus, the longer the loan period, the higher would be the total interest. So if you borrow $50,000 at 2.2% flat rate over 10 years, total interest = $50,000 x 2.2% x 10 years = $11,000 instead of $7,700 if you repay over 7 years.


DJ I-Ling: Thank you Dennis for sharing with us the various returns. Now is the time for listeners to call in now if you have questions.

[Apple mei]

Hi mr Dennis Ng ,

Enjoy your articles .

1) I once see a promotion for a investment . It is OCBC 88 day time deposit.
It stated in advertisment that for first 88 day the interest rate will be 4.08% pa and the interest rate will be 2.10% pa for the next 88 days . Effective interest rate is 3.10% pa .

1a) May I know the difference between effective interest rate and interest rate ?

1b) How they get the effective interest rate of 3.1% pa ? because if you add the 2 interest rate divide by 2 is shall be 3.09%.

2) I once pass by a investment show and is offer a wrap account for unit trust and the financial adviser say the when you buy unit trust from them ,there will not be any fee incured . He mention there will not be any front end or back end charges (whenyou buy fund from them)or switching fee involved when you switch fund . Is this possible becuase even when buy find online ,example fundsupermart.com or dollerdex.com ,there will charge 1-5% of the investment as sales charges .What could be the catch?

3) In your last mandrain seminar with zhaobao, you mention it is not a good time to buy anunity now because interest rate is low . In your opinon ,what shall be the miniunum interest rate that the insurance/bank are offering before we consider anunity to be attractive again.

Apple mei

[Dennis Ng]

Hi mr Dennis Ng ,

Enjoy your articles .

1) I once see a promotion for a investment . It is OCBC 88 day time deposit.
It stated in advertisment that for first 88 day the interest rate will be 4.08% pa and the interest rate will be 2.10% pa for the next 88 days . Effective interest rate is 3.10% pa .

1a) May I know the difference between effective interest rate and interest rate ?

1b) How they get the effective interest rate of 3.1% pa ? because if you add the 2 interest rate divide by 2 is shall be 3.09%.

2) I once pass by a investment show and is offer a wrap account for unit trust and the financial adviser say the when you buy unit trust from them ,there will not be any fee incured . He mention there will not be any front end or back end charges (whenyou buy fund from them)or switching fee involved when you switch fund . Is this possible becuase even when buy find online ,example fundsupermart.com or dollerdex.com ,there will charge 1-5% of the investment as sales charges .What could be the catch?

3) In your last mandrain seminar with zhaobao, you mention it is not a good time to buy anunity now because interest rate is low . In your opinon ,what shall be the miniunum interest rate that the insurance/bank are offering before we consider anunity to be attractive again.

Apple mei

My comments:
1. effective interest rate as the name imply, is the "real" and "effecitve" interest rate you earn. You cannot just add the 2 interest rate and divide by 2, becos you already forgot the "power of compounding" at work. This is a common misconception many people have.

2. Zero bid-offer spread is not impossible. What the advisor forgot to tell you is that they charge an extra annual fee on top of the annual management fee, which can be 1% or higher. Remember, there's no free lunch. If you pay for lunch, you also expected to pay for someone to do this work of investing for you. So whether you pay bid-offer spread which is one-time or a recurrent extra annual fee eg. 1%, which is cheaper? I think no clear answer. Key is find a Financial Planner that put your interests above his/hers, very rare, but there're some around. Open you eyes wide to try to spot them.

3. What is a good return? In my opinion, for annuity to be attractive, the annual returns should be about 4% and higher. Why? Becos risk of inflation, if inflation rate is 3%, any lower returns than 3% you would end up "becoming poorer and poorer over time". It's possible to earn 5% annual returns or even higher and not take a lot of risks. The key is "asset allocation". This seems to be a simple concept but many people fail to implement it. eg. if all your assets are in S$, you're already putting all your eggs in 1 basket and taking very high risks and not doing "diversification" but without yourself knowing the dangers.

Ask the Japanese, ask the Indonesians, the thais....many of them regretted putting all their eggs in their native country currency. When I was working in the bank in the Asian crisis, I saw with my own eyes how many tycoons who made this mistake get wiped out (yes, totally wiped out). Those who do proper asset allocation, today, some of them have "recovered" from the crisis and making waves again.

Why learn from your own mistake? Learn from others' mistakes and avoid making them yourself. That's a smarter and faster way to learn. I called it "leveraging on others' experience". You can see I truly believe in the concept of "leverage". Otherwise, I will not name my company "Leverage".

Cheers!

Dennis Ng, http://www.HousingLoanSG.com - we help you get the best deal in Housing Loans in Singapore!