COMPUTING INTEREST

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COMPUTING INTEREST
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INTEREST COST

• IS A MAJOR EXPENSE
• VARIES WITH INTEREST RATE
• VARIES WITH THE METHOD USED TO CALCULATE INTEREST

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METHODS OF CALCULATING INTEREST

• SIMPLE INTEREST
• REMAINING BALANCE
• ADD ON METHOD

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Computing Interest
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Simple interest

• Very Simple
• Used Primarily on Short Term Loans

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Simple Interest Example
1000 borrowed for 1 year at 5 interest
1000 x .05 50 interest charge 1050 to be
paid back at the end of the loan
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Remaining Balance Method

• Used when several payments are to be made
• Interest is charged only on the remaining
  principal balance

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Remaining Balance Method
Example

• 1000 borrowed for 4 years at 8 interest.
• The 1000 will be paid back in yearly principal
  installments of 250.

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Remaining Balance Method

• YEAR 1
• 1000 X .08 (interest rate) 80 interest cost
• 250 Principal Payment
• 330 Annual Payment

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Remaining Balance Method

• YEAR 2
• 750 X .08 (interest rate) 60 interest cost
• 250 Principal Payment
• 310 Annual Payment

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Remaining Balance Method

• YEAR 3
• 500 X .08 (interest rate) 40 interest cost
• 250 Principal Payment
• 290 Annual Payment

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Remaining Balance Method

• YEAR 4
• 250 X .08 (interest rate) 20 interest cost
• 250 Principal Payment
• 270 Annual Payment

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Remaining Balance Method
Total Interest Paid

• 200
• Over a Four-Year Period

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ADD ON METHOD

• Interest charged on full principal amount for the
  entire life of the loan.
• Total interest amount is added to principal and
  divided into even payments

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Add On Interest Example
Example
1000 borrowed for 4 years at 8 interest.
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Add On Interest Example

• Step 1 Calculate the total interest paid over
  the lifespan of the loan
• 1000 (principal amount)
• X
• .08 (interest rate)
• x
• 4 (years)
• 320 Interest Charge
• This 320 is the Interest Charge (or the total
  amount of interest paid over the lifespan of the
  loan)

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Add On Interest Example

• Step 2 Add the interest charge to the
  principal amount
• 1000 (principal amount)
• 320 (Interest Charge)
• 1320 (Total amount paid)

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Add On Interest Example

• Step 3 Divide total amount paid by the total
  number of payments
• 1320 (total amount paid)
• /
• 4 (years)
• 330 Yearly Payment
• Notice that the total Interest Charge is 120
  higher using the Add-On method than with the
  Simple Interest Method.

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Calculating APR (using Add-On Method)
R 2C X 100 L (P A)
Formula Key R Annual Percentage Rate C
Total Interest Cost L Length of Loan in
Years P Principal Amount Borrowed A Payment
Amount Each Period
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Add On Interest Example
Actual APR
R 2(320) X 100 4 (1000 330)
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Add On Interest Example
Actual APR
R 12.03

• This APR is MUCH higher than the original 8
  interest originally charged
• (4.03 more)

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Jeopardy Moment