You are borrowing $400 (P) for 1.5 years (T) and you will owe a $60 finance charge (I). But is that the effective interest rate? To find out, use above effective interest rate formula, and assume the number of yearly payments is 12, and the total number of payments is 18. The calculation would look like this:
charge. You would receive only $305 but you would pay back the total amount borrowed ($400) in 18 equal monthly payments. The APR is much higher because you would have use of less money.
APR = 2 x 95 x 12 / 400 x (18+1) = 2280 / 7600 = 30%
APR = 2 x 60 x 12 / 460 x (18+1) = 1440 / 8740 = 16.5%
In addition, you would not have enough money from the loan to buy the washing machine with the discounted loan.
The amount to be repaid includes your $400 loan plus the $60 finance charge or $460.
Why Determine True Cost of Borrowing
Let’s further assume that the lender requires a loan ap- plication fee of $10 and a processing fee (credit check) of $25 in this situation. The annual percentage rate now needs to reflect the increase in the total finance charge from $60 to $95. So the calculation would be:
APR = 2 x 95 x 12 / 495 x (18+1) = 2280 / 9405 = 24%
You can determine the true cost of borrowing to verify the APR when your payment schedule calls for regularly occurring payments of equal amounts. Remember the lender is required to tell you the effective APR and the total finance charge. To get credit at the least cost, shop in two or three places for the lowest APR and total finance charge.
In this example, the lender stated a simple interest rate of 10 percent. Yet you actually are paying an effective APR of 24 percent once you add in the fees and you do not have the use of the full loan for the entire loan period.
Compare the cost of credit in terms of time. The longer it takes you to repay a loan the higher your finance charge will be.
Resources Used in This Publication
Garman, E. T. and Forgue, R. E. (2006). Personal finance (8th ed.). Boston, MA: Houghton Mifflin Co.
Some lenders want their interest in advance. They make discounted loans where the finance charge is deducted from the amount you borrow when you take out the loan. If the loan in the previous example where you borrowed $400 was a discounted one, the lender would subtract the $95 finance
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Index: Financial Management
Credit and Debt Issued November 2007
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