Effective Interest Rates Sub-chapters: Introduction Definition Uses Methodology What is included in an EIR calculation? What is not included in an EIR calculation? Examples of differences in EIRs Disclosure European standards Introduction There are lots of different types and definitions of interest rates in the financial markets and this can easily cause confusion for consumers. This article explains one type of interest rate - the ‘effective interest rate", which we will refer to as EIR in this article. It is a measure that consumers should understand and look at closely when they are negotiating a loan or deposit contract with a bank or micro-credit organization as it gives them the best measure of the real cost to them of a proposed loan or the real return they would get on a deposit. Definition An effective interest rate (EIR) is the cost to a borrower or the return to a depositor after all fees and costs related to the loan or the deposit are included in the calculation of the interest rate. Uses Effective interest rates are important because they allow potential customers to quantify and easily compare the costs of a similar financial product among various banks or to compare the costs or returns among products that have different fee schedules and other conditions. For example, they can compare the effective cost of a loan that has a 10% nominal interest rate and no fees against one that has a8% nominal interest rate plus a set-up fee of KM 200 and monthly service fee of KM 10. Methodology The Banking Agencies of the Federation (FBA) and the RS (RSBA) have both set out by Regulation the methodology that financial institutions licensed by them have to use to calculate the EIRs on their products. These requirements apply to: Both loans and deposits; Both banks and micro-credit institutions. There are some differences between the methodologies that are currently being imposed by the two entity's banking agencies While these differences are not substantial, they do have the following impacts on customers use of EIR information in BiH: While it is possible to accurately compare EIRs for similar products amongst banks in the Federation OR amongst banks in the RS, comparisons of EIRs between banks in the Federation and banks in the RS is not possible to some types of loans; The RS Regulation has a broader definition of costs that have to be included in the EIR calculations, including some costs that are not directly related to the bank loan. This means that EIRs will tend to be higher for the same product in the RS than in the Federation. It is expected that these methodological differences will be corrected in the near future. Bank and micro-credit customers will then be able to compare EIRs amongst all banks or all micro-credit institutions in BiH. What is included in an EIR calculation? The following are the main items that are included in the calculation of an EIR: i) The nominal interest rate. This is the rate that is quoted by the bank as the interest rate on the contract. This is the rate that banks often focus on in their publicity and the one that customers have paid most attention to in the past. But once other costs related to a loan are also included, the ‘effective' interest rate a customer is paying may be significantly different to the stated ‘nominal interest rate' on a loan; ii) The time-schedule of the interest payments: for example, the EIR interest rate on a deposit that has a ‘nominal interest rate' of 4% will differ between a deposit that pays interest annually at the end of the year and one that pays interest quarterly during the year. The frequency of payments also changes the EIR on a loan. The more frequently a borrower has to make interest payments, the higher the EIR will tend to be; iii) Fees and charges that have to be paid to get the loan or make the deposit; iv) All foreseeable and forecastable future fees, charges and price changes that will have to be paid during the life of the contract. What is not included in an EIR calculation? It is also important for consumers to know what costs are NOT included in most EIR calculations. The most important ones are: i) Costs that are not linked to the credit or deposit: costs that are not a direct consequence of the credit or deposit are usually not included in the calculation of an EIR. For example, the customer may have to pay a fee to register a property. This is a cost of the property transaction that the customer needs to be aware of as they need to ensure they have the funds to meet these other property-related costs. But this fee needs to be paid even if the property is purchased without taking out a loan. So it is not usually treated as a part of the EIR of the loan. In the RS, some costs such as these are currently included in their EIR calculation; ii) Costs and prices that are not foreseeable or forecastable at the time that the contract is being negotiated: It is very important that a consumer understands that only foreseeable and forecastable future costs are included in the eir calculation the consumer will be given at the time of negotiating a contract. This is so significant for products such as variable rate loans and foreign currency loans and deposits that we will explain it further. Variable rate loans: For a variable rate loan, the EIR given to the customer at the time of the negotiation of the loan assumes that the interest rate on the loan at the moment of contracting won't change during the life of the loan.. But the customer needs to understand that the bank does have the contractual right to change this rate during the life of the loan,The important point for customers to be aware of in regard to the EIRs on is that this EIR will change every time the bank varies the nominal interest rate on the loan. Any changes to the nominal interest rate and the impact that this has on the EIR of the loan have to be advised to the customer BEFORE the new EIR takes effect. However, the bank has to include in the contract the basis they will use to change the rate, the frequency with which they can change the rate and every time they change the nominal interest rate, they are required to calculate a new EIR and tell the customer the new EIR in advance. So the changes in EIRs have some limitations on both the likely size of each change and their frequency in the RS (Similar proposals have been presented in the Federation and will be passed soon). Foreign currency loans:In principle, only EIR for the loans in the same currency can be compared. If loans are in different currencies or indexed to different currencies,then the customer can not directly compare their EIRS. i) The changes in some of these exchange rate changes CAN have VERY SUBSTANTIAL effect on EIRs. For example, an EIR that is calculated as being only around 4-5% when the loan contract is signed could easily end up being as much as 30-40% a year or two later. This is not just a theoretical possibility. Such enormous changes in EIR on foreign currency loans have been faced by some BiH borrowers in recent years. ii) Foreign currency exchange rates change every day - even during a day. So the effective interest rate on a foreign currency loan is also changing all the time. It is therefore not possible for a bank to calculate a new EIR in advance and advise the customer as they are required to do for variable rate loans.The customer needs to be fully aware of this major deficiency that the high risks of borrowing in a foreign currency are not included in an EIR calculation. The deficiency can be partially mitigated if: The banks inform the customers during the negotiations for a foreign currency loans that the EIR is calculated on the assumption that the exchange rate won't change. However the exchange rate in practice will change. The banks should also provide the customer and the customer should ask for some numerical examples of various changes in the exchange rate. The bank should regularly recalculate the EIR and inform their customers While the current regulations in BiH do not currently require banks to do these things in relation to EIRs on foreign-currency loans, banks should offer and clients should ask banks to do them as a service to their customers in order to improve the accuracy and amount of information. . Examples of differences in EIRs The following example calculates the different EIRs for three loans that have the same nominal interest rate, maturity and payment schedule BUT have different fee structures: a) A loan agreement for a total amount of credit of Euro 6000 repayable in 24 equal monthly installments of Euro 274.11 that has no fees or other payments. The EIR on this credit is 9.4%; b) A loan for the same amount and with the same 24 monthly payments but with an administrative charge of Euro 60 payable when the contract is signed. With this administrative charge added, the EIR on the credit increases to 10.5% (ie, the fee increases the EIR by 1.1%; c) The same conditions as in b) with the addition of insurance costs of 5% of the credit limit spread over the 24 monthly repayments. This insurance payment increases the EIR on this credit to 15.5%. This insurance payment is high but it is used to illustrate how significantly EIRs can be increased by fees and charges. In this example, the EIR is over 60% higher than the EIR on the first loan that has no fees. Disclosure i) Both Banking Agencies require an EIR to be calculated using the methodology they have prescribed by all bank or micro-credit organizations for all loans and deposit contracts; ii) This EIR has to be clearly stated in the contract and the payments plan. When negotiating with a bank, consumers should insist that this is done if the bank does not provide it; iii) The EIR must be communicated to a client BEFORE a contract is signed; iv) Actual EIRs must be visibly displayed in all bank branches and promotional material and should be given as much emphasis as the nominal interest rate; v) If the EIR changes for any reason, the bank must communicate this to the client before the new EIR takes effect. (NB, as said above, this isn't possible for foreign currency loans as the EIR on this type of loan is changing all the time). These BiH disclosure requirements for EIRs are good and are an important part of the improved consumer protection measures the Banking Agencies have introduced in BiH in recent years. European standards The EIR Regulations in BiH are closely aligned to European standards but at present have some differences: i) The Regulations in BiH apply to all bank clients, including business clients. European Regulations usually apply just to ‘consumers. This appears to be based on the assumption that large, business customers have the financial knowledge and capacity to judge financial products for themselves. The events in many countries in the recent financial crisis lead one to have doubts about the accuracy of this assumption. The broader coverage in the BIH Regulations increases the amount of disclosure of important financial information and thus should therefore improve the safety of the BiH banking system. ii) In most European countries, the EIR Regulations apply only to loans. BiH Regulations apply to deposit contracts too. The inclusion of EIRS on deposit is also beneficial for consumer information and protection. Fees and other charges lead to a difference between the nominal interest rate and the EIR on a deposit in exactly the same way that they do for loan contracts; iii) The EIR Regulations in the RS include some fees that are not related directly to the loan (as was described previously).
