Interest or “Finance Charge” can be calculated or determined in several different ways. That is the reason why the Federal Reserve Board decreed a standardized method of describing the rate of Finance Charge on a given consumer credit transaction. By inventing the “Annual Percentage Rate” and requiring its use and disclosure, the FED has enabled consumers to compare “apples to apples,” and not throw in an orange.
Annual Percentage Rate or “APR” is the uniform method of stating the cost of credit over time. So, without regard to the way that Finance Charge is determined by the creditor, the Federal Truth in Lending Act requires the reporting of the rate to the consumer in a uniform manner.
Let's get academic for a minute and review four methods that creditors commonly use to calculate interest on loans. I will use a $1000 loan example for one year, where the creditor wants to earn $120 in Finance Charge. Sounds simple enough. 12% APR should do it, right??? Wrong. [Sorry in advance for the math below, but it is the only way to demonstrate what happens if different interest-earning methodologies are employed.]
1. Simple Interest. In this interest-earning computation, the consumer has the use of the entire principal amount for one full year, and at the end of the year, repays the principal + interest—$1000 principal + $120 Finance Charge, for a total of payments of $1120. The Annual Percentage Rate matches the simple interest rate for a 12% APR. Since state laws generally require that installment credit be repaid in substantially equal payments and restrict “balloon payments,” creditors in consumer transactions generally cannot use this true “simple interest” computation.
2. Interest Bearing. Some creditors use the “interest bearing” methodology. In a loan that is based on the interest bearing concept, Finance Charge is earned daily and payments are set up to be made at pre-agreed, equal intervals in equal amounts. If the consumer makes a payment early, then less Finance Charge is earned by the creditor, as the principal amount is repaid more quickly than agreed. Similarly, if payments are made late, then more Finance Charge is earned. On an interest bearing basis, if payments are paid exactly as agreed, the sample $1000 transaction results in the principal repayment of $1000 + Finance Charge of $120, for a total of payments of $1120. However, the APR for such an interest bearing loan is 21.45%. The reason that the APR is higher than in Method 1. is that the consumer does not have use of the entire $1000 of principal for the entire year. (Interestingly, a state rate of 12% on this type of loan would yield $166.52 of Finance Charge and the APR would be 29.44%.)
3. Precomputed Interest. Some states permit “precomputed interest.” In a loan where Finance Charge is precomputed and “added-on,” the Finance Charge is determined at the outset of the loan. So, the $120 of Finance Charge is added-on to the $1000 of principal to arrive at the total of payments of $1120. Same as in the examples above. The monthly payment amount on this pre-computed loan is $93.33. The APR is 21.45%. This APR also is higher than in Method 1. for the same reason as in Interest Bearing—the borrower does not have use of the entire $1000 of principal for the entire year. (A state rate of 12% on this type of loan would yield $166.16 of Finance Charge and the APR would be 29.38%.)
4. Amortized Interest. In a loan where Finance Charge or interest is amortized, the payments are equal, but each payment amount consists of a differing amount of principal and Finance Charge. The most common form of an amortizing loan is a traditional mortgage loan. So, a $1000 principal loan with interest amortized at 12% will result in monthly payments of $88.85. Principal of $1000 will be repaid + $66.02 of interest for a total of payments of $1066.02. The APR on this loan is 12%. (In order for a creditor to achieve a return of $120 of Finance Charge on an amortized basis, the APR would have to be 21.45%.)
So, you see how a desired $120 of earnings results in differing APRs depending on the interest-earnings methodology used. And, you can see that charging “12%” yields vastly different results depending upon methodology. This is why the concept of an APR, is so important. It is a measuring stick for the cost of credit over time. Also, keep in mind that the prepayment computation will yield different results depending upon the interest-earning methodology used.
Practice Pointer: Double check with your software provider to make certain that your statement of the Annual Percentage Rate on your loans and credit sales is true and accurate.