Learning Objective # 2

Determine the effective cost of borrowing by considering the quoted rate, the number of compounding periods, the timing of interest payments & other service charges.

LO#2

The Cost of Credit

Effective Annual Interest Rate depends on; Quoted annual percentage rate How frequently interest is

compounded Interest charged up front Other charges such as service

charges, credit-related insurance premiums, and appraisal fees

LO#2

The Cost of Credit

The Annual Percentage Rate (APR) is the percentage cost of credit on a yearly basis May be compounded more frequently Thus Effective Annual Interest Rate may be

higher than Annual Percentage Rate The APR provides the true rate of

interest for comparison with other sources of credit. This rate lets you compare like with like when shopping for rates.

LO#2

Effective Annual Percentage Rate

Is calculated using the following formula Where m equals number of times per year

interest is compounded

LO#2

E A R = (1 + APR/m)m - 1

Trade-Offs of Financing Choices Term (length of loan) versus interest

cost. A longer term allows lower monthly

payments, but you pay more in interest. Lender risk versus interest rate. To

reduce the lender’s risk you can... Accept a variable interest rate. Provide collateral to secure the loan. Make a large down payment up front. Have a shorter loan term.

LO#2

Calculating Your Loan Payments

Fixed Rate Installment Loan Pay off over a pre-determined period of time Payment represents blend of interest and principal

Floating Rate Personal Line of Credit Variable interest rate tied to lender’s prime rate Compounded daily Payments not fixed

At risk if interest rates rise Takes longer to repay if only paying minimum

required

LO#2

Cost of Carrying Credit Card Balances

Adjusted balance method The assessment of finance charges after payments

made during the billing period have been subtracted.

Previous balance method Method of computing finance charges that gives no

credit for payments made during the billing period. Average daily balance method

Uses a weighted average of the account balance throughout the current billing period. If you carried over a balance new purchases may be included in your average daily balance calculation.

LO#2

The Cost of Credit

Expected Inflation borrowers and lenders are concerned

about the goods and services their dollars can buy - its purchasing power

inflation erodes the purchasing power of money

the expected rate of inflation is added to the interest rate charged by lenders to protect their purchasing power

LO#2

The Cost of Credit

Avoid the minimum monthly payment trap minimum monthly payment is the smallest

amount you can pay and still be a cardholder in good standing

is not the total amount due the longer you take to repay the more

interest you will incur Credit Insurance

ensures the repayment of your loan in the event of death, disability or loss of property

pays lender directly

LO#2