Getting a personal loan might be easy enough, but do you really understand what it will cost you? Today banks use some pretty complicated formulas to work out the interest you will pay. But even though each loan might be a bit different, there are a few basic rules that everyone should know before getting a personal loan.

Here we at GET.com have listed 3 of the most important, from the simplest to the most complicated.

  1. Don't fall for sign-up rewards

    Banks make money off loans, so many lenders offer free luggage and other rewards to convince you to get your personal loan from them. Rewards are good and fine, but they should be the last thing you consider when looking for the right loan.

  2. Understand Simple Interest Rates (SIRs)

    As their name implies, these rates are pretty easy to understand. The simple rate for a $1,000 loan with a 3 year tenure and an 8% per annum interest rate would be 8%, or $80 per year. The EIR is based on this simple rate.

  3. Calculate the Effective Interest Rate (EIR)

    These somewhat complex rates are probably responsible for more rip-offs and confused borrowers than anything else. This rate is calculated based on compound interest, and pretty much works like this. If you borrow $1,000 for 3 years, with an interest rate of 8% per year, you will pay:

    • $80 (8% of $1,000 or $80 total interest) the first year.
    • $86 (8% of $1,000+$80 or $86 total interest) the second year.
    • $93 (8% of $1080+$86 or $93 total interest) the third year.

Just add the interest on the loan and the interest rate each year to find the EIR. Of course there are variations of this, depending on the details of your loan (monthly or annual interest rate, whether money paid in is discounted and other factors).

So borrowing $1,000 at 8% annual interest only means an $80 interest charge if the loan tenure is no longer than 1 year. If your tenure is 3 years you will pay $80+$86+$93 or $259 total interest, instead of the $240 implied by the simple interest rate (the one lenders often quote you).

In most cases, the full EIR will be calculated based on your loan tenure (the time you have to pay) and your monthly charges will reflect the full cost. The longer your loan tenure, the higher your EIR will be.

However, you should note that the example above shows the simplest form of EIR, as it uses annual compounding. Some loans compound interest quarterly, monthly or even daily, which means the annual interest charges are divided over either 12 months, 4x3 months or 365 days, and you pay interest on the interest charged that day, month or quarter.

So $86 annual interest (8% SIR on a $1000 personal loan) divided by 12 months, in the case of monthly compounding, would come to $7.16 per month. The first month you would pay $7.16, the second month 8% of that $7.16, or $0.57, would be added, so you would pay $7.73 interest ($7.16 + $0.57). The third month 8% of the $7.73 interest, or $0.61, would be added, so you would pay $8.34 interest that month. This goes on every month over the life of your loan, and in the end it adds up to more interest than you would pay with yearly compounding.

Over the life of your loan, the way the interest is compounded (daily, monthly, annually) can make a pretty big difference in the amount of interest you pay on your loan. As a rule, you should ask the bank what the total cost of the loan would be, taking the EIR and compounding interest into account. Get this on paper if you can. You might be surprised by how much a personal loan will actually cost you.