What Is an Effective Interest Rate (EIR)?: Why It Matters to Credit Cardholders

Credit cards have become more than just a convenient payment method—they’re also key to financial management for many. Plus, proper credit card use is also good for building a credit history.

If you’re holding one of the issued 11.8 million credit cards in the Philippines, you enjoy the perks of swiping it whenever you shop online or in stores. Yet, with this ease comes the need to understand credit card costs, especially credit card interest rates.

Understanding the Effective Interest Rate (EIR) will help you appreciate how you spend as a credit cardholder—it influences the total borrowing cost and impacts your financial well-being.

Let’s unpack this financial jargon to help you grasp it properly. After reading this, I hope you will make smarter financial decisions, avoiding debt accumulation and financial stress.

Everything You Need to Know About Effective Interest Rate (EIR)

• What is an effective interest rate (EIR)?
• How does EIR work when using a credit card?
• Where do you look for the effective interest rate in your credit card documents?

What is an effective interest rate (EIR)?

The Effective Interest Rate, also known as the annual equivalent rate or effective annual rate, is the interest rate on a loan or investment adjusted for the number of compounding periods during the year. EIR provides a more accurate measure of the actual cost of borrowing money or the real return on investment, considering the effects of compounding interest and any additional fees associated with the financial product, like a credit card.

via GIPHY

The Effective Interest Rate (EIR) for credit card users is like the real cost of using your credit card over a year. It considers the interest rate your bank tells you and how often that interest is added to your balance.

Think of it this way: when you use your credit card to make purchases and don’t pay off the balance immediately, the bank charges you interest. This interest can compound, meaning it can be calculated and added to your existing balance regularly (like every month), which increases the total amount you owe.

You’ll know more about this in the next section.

How is EIR calculated in unpaid credit card balances?

This is a must-read if you don’t always pay your credit card’s total amount due every month. EIR includes the nominal interest rate (or stated annual interest rate on a loan or investment, not accounting for inflation) and considers the effects of compounding within a given period.

You can understand EIR in credit card use in two ways: retail purchase and cash advance.

EIR in retail purchase

Image: HSBC Philippines

Let’s break down the sample interest computation above after you bought a laptop worth ₱50,000 using your HSBC credit card. But for some reason, due to emergencies and additional expenses before the due date, you ended up only paying a portion of the total amount due on the next billing cycle.

When you don’t pay the full amount you owe right away, the bank charges you a little extra each month. This extra amount is called “interest.” In this example, the effective interest rate is 2.89% per month.

Here’s what happens each month:

• Month 0: You buy the item for ₱50,000.
• Month 1: You pay ₱2,500
• Month 2: You pay another ₱2,500
• Month 3: You pay another ₱2,500
• Month 4: You pay another ₱2,500
• Month 5: You pay another ₱2,500
• Month 6: You pay another ₱2,500

In summary

• Effective interest rate. 2.89%.
• Principal amount. The original amount you borrowed is ₱50,000
• Total payment from you. Each month, you pay ₱2,500.
• Outstanding principal balance. The amount you still owe without interest.
• Total outstanding balance. The total amount you owe, including interest.

What does it all mean? EIR shows the compounding effect of the interest charged on your outstanding principal balance each month if you don’t pay the total amount due.

Imagine that EIR always eats up your money when you only settle partial payments.

The first interest charge (₱1,243) is almost half the total amount you paid, which is ₱2,500.

EIR in cash advance

Image: HSBC Philippines

If you use the cash advance feature, remember that your issuer will charge you a processing fee. In this case, HSBC has a flat rate processing fee of ₱200. The monthly EIR in this sample computation is 3.04%.

What happens when you don’t pay in full in cash advances?

1. Increased interest costs

• Over six months, you pay a total of ₱3,194 in interest.
• This money goes directly to interest rather than reducing your principal balance.

2. Slow reduction of principal

• Despite you’re making total payments of ₱9,000 (₱1,500 x 6), your outstanding principal only reduces from ₱20,200 to ₱15,423.
• The effective reduction in principal is just ₱4,777 due to the significant portion of your payments covering interest.

3. Higher total repayment amount

• Total repayment after 6 months: Payments (₱9,000) + Remaining Balance (₱15,894) = ₱24,894.
• The initial loan was ₱20,000, so you end up paying an additional ₱4,894 over six months, mostly due to accumulated interest.

4. Compounding interest

• Interest on outstanding balances compounds, leading to higher costs over time.
• Each month, a portion of your balance accrues more interest, even as you make payments.

This scenario makes it difficult to decrease the core loan amount, risking extended financial distress and possibly sleepless nights if you always do this for the long term.

Where do you look for the effective interest rate in your credit card documents?

• Monthly statement. The EIR is often detailed in the monthly statement you receive from your credit card issuer. Look for sections that discuss finance charges or interest calculations.
• Credit card agreement. This document outlines all terms and conditions related to your credit card. The EIR and other rates, such as the nominal interest rate and any applicable fees, should be clearly stated here.
• Welcome kit. When you receive your credit card, it typically comes with a welcome kit that includes important information about the card’s interest rates, terms and conditions.

Final thoughts

I used to think that borrowing money from credit cards was pretty straightforward, like being charged for the monthly interest as shown on the marketing collateral and credit card promos. But in reality, the actual costs are only promoted and disclosed if you dig deeper and scrutinize the terms and conditions.

I’m sure not everyone is keen to read everything, including myself. That’s why, when I was still money-dumb, I was shocked to see the actual computations of unpaid balances on the statement of account.

Take my advice. Before you commit to credit card installments and promos, you must know the actual cost of using credit cards, especially when you pay only the minimum amount due every billing cycle.

Are you aware of EIR as a credit cardholder or is this the first time you encountered this word?

Share this article with anyone interested who’s been struggling with credit card debts.