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Hi
If you take a loan of $100 at 5% compounded interest per year, and pay for it over 12 months, you'd have paid the following:
Monthly Payments - $8.56
Total Payments - $102.73
That is clearly less than 5% interest. In fact, intuitively, you'd have expected to pay > 5% in effective interest rate. Yet you don't even pay 5% in interest!
How does this work out??
(Headbang)
if you took out the loan and paid nothing till the end of the year, then you pay $105 at the end of the year.
by making regular monthly payments you decrease the principal owed, hence the interest is calculated on a regularly decreasing amount.
This is what the "loan account" looks like:
Add up the 12 "interest" amounts (get the other 8 yourself!) and you'll get 2.73.Code:MN PAYMENT INTEREST BALANCE
00 100.00
01 -8.56 .42 91.86
02 -8.56 .38 83.68
....
11 -8.56 .07 8.52
12 -8.56 .04 .00