COMPUTING INTEREST

INTEREST COSTIS A MAJOR EXPENSE

VARIES WITH INTEREST RATE

VARIES WITH THE METHOD USED TO CALCULATE INTEREST

METHODS OF CALCULATING

INTEREST

SIMPLE INTEREST

REMAINING BALANCE

ADD ON METHOD

Simple interestVery Simple

Used Primarily on Short Term Loans

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

Remaining Balance Method

Used when several payments are to be made

Interest is charged only on the remaining principal balance

Remaining Balance Method

•$1000 borrowed for 4 years at 8% interest.

•The $1000 will be paid back in yearly principal installments of $250.

YEAR 1:

$1000 X .08 (interest rate) = $80 interest cost

+$250 Principal Payment $330 Annual Payment

Remaining Balance Method

Remaining Balance Method

YEAR 2:

$750 X .08 (interest rate) = $60 interest cost

+$250 Principal Payment $310 Annual Payment

Remaining Balance Method

YEAR 3:

$500 X .08 (interest rate) = $40 interest cost

+$250 Principal Payment $290 Annual Payment

Remaining Balance Method

YEAR 4:

$250 X .08 (interest rate) = $20 interest cost

+$250 Principal Payment $270 Annual Payment

Remaining Balance Method

•$200

•Over a Four-Year Period

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

Add On Interest Example

$1000 borrowed for 4 years at 8%

interest.

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)

Add On Interest Example

Step 2: Add the interest charge to the principal amount

$1000 (principal amount) +

$320 (Interest Charge) $1320 (Total amount paid)

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.

Add On Interest Example

Calculating APR (using Add-On Method)

R = 2C X 100L (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

Add On Interest Example

R = 2($320) X 1004 (1000 + 330)

Add On Interest Example

R = 12.03%

•This APR is MUCH higher than the original 8% interest originally charged

•(4.03% more)