Rate.
3. The Cost of Credit: Annual Percentage Rate
Introduction
The annual percentage rate (APR) is a true measure of the effective cost of credit. It is the ratio of the finance charge to the average amount of credit in use during the life of the loan, and is expressed as a percentage rate per year.
How is it computed?
We present below a discussion of the way the effective APR is calculated for various types of loans.
Single-Payment Loans
The single-payment loan is paid in full on a given date. There are two ways of calculating APR on single-payment loans: the simple interest method and the discount method.
1.Simple interest method
Recall from Sec. 1 that, under the simple interest method, interest is calculated only on the amount borrowed (proceeds):
Example 1
A business owner took out a single-payment loan of $1000 for 2 years at a simple interest rate of 15 percent. The interest charge is: $300 ($1,000 × 0.15 × 2 years). Hence the APR is:
Under the simple interest method, the stated simple interest rate and the APR are always the same for single-payment loans.
Discount method
Under the discount method, interest is determined and then deducted from the amount of the loan. The difference is the actual amount the borrower receives. In other words, the borrower prepays the finance charges.
Example 2
Using the same figures as in Example 1, the actual amount received $700 ($1,000 - $300), not $1,000. The APR is:
The rate the lender must quote on the loan is 21.43 percent, not 15 percent.
The discount method always gives a higher APR than the simple interest method for single-payment loans at the same interest rates because the proceeds received are less.
Installment Loans
Most consumer loans are the add-on method. One popular method of calculating the APR for add-on loans is the constant-ratio method. The constant-ratio formula is:
Example 3
Assume that a business owner borrows $1,000 to be repaid in 12 equal monthly installments of $93 each for a finance charge of $116. The APR under the constant-ratio method is computed as follows:
Note that some lenders charge fees for a credit investigation, a loan application, or for life insurance. When these fees are required, the lender must include them in addition to the finance charge in dollars as part of the APR calculations.
How is it used and applied?
The lender is required by the Truth in Lending Act (Consumer Credit Protection Act) to disclose to a borrower the effective annual percentage rate (APR) as well as the finance charge in dollars.
Banks often quote their interest rates in terms of dollars of interest per hundred dollars. Other lenders quote in terms of dollars per payment. This leads to confusion on the part of borrowers. Fortunately, APR can eliminate this confusion. By comparing the APRs of different loans, a borrower can determine the best deal.
Example 4
Bank A offers a 7 percent car loan if a business owner puts down 25 percent. That is, if the owner buys a $4,000 auto, she will finance $3,000 over a 3-year period with carrying charges that amount to $630 (0.07 × $3,000 × 3 years). The owner will make equal monthly payments of $100.83 for 36 months.
Bank B will lend $3,500 on the same car. In this case the business owner must pay $90 per month for 48 months.
Which of the two quotes offers the best deal?
The APR calculations (using the constant-ratio formula) follow.
In the case of Bank B, it is necessary to multiply $90 × 48 months to arrive at a total cost of $4320. Therefore, the total credit cost is $920 ($4,320 - $3,500).
Based on the APR, the business owner should choose Bank B over Bank A.
4. Calculating Due Dates
Introduction
The due date, also called maturity date, is the exact date when a loan must be repaid.
How is it computed?
Some loans specify the maturity date while other loans state the period of the loan in days or months. When the maturity date is given in days, the date is determined by counting the days from the day the loan was secured. The day on which the loan is procured is not counted. For example, a 120-day loan obtained on October 17, 20×7, is due on February 15, 20×8. When the period is given in months, the loan’s maturity date falls on the same day of the month as the date the loan is issued. For example a 6-month loan dated March 15 matures on September 15. If the due date of the loan falls on a nonbusiness day, the maturity date is the next business day, with an additional day(s) added to the period for which interest is charged.
Example
Motor Parts, Inc., obtained a 90-day loan dated March 16, 20×7. The maturity date of the loan is June 15, 20×7, as determined below.
To determine the maturity date, calculate forward for the exact number of days in the loan period. Do not count the day on which you actually received the loan. Remember that some months have 30 days and some have 31.
How is it used and applied?
Due dates are not approximations; they are precise and final. On that date, you must be prepared to make full payment. Failure to do so means that you have defaulted on a loan and that can have disastrous consequences for your business.
It is critical, therefore, that you know the exact date well in advance so you can make certain you will have the funds available.
5. Promissory Notes and Bank Discounts
Introduction
A business may both make a promissory note and receive one. Notes receivable and notes payable are formal arrangements promising payment. Often a debtor signs a promissory note, which serves as evidence of a debt. The promissory note is a written promise to pay principal with interest at a maturity
