Thread: interest rates calculation: how does this work out?

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??

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:

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

Add up the 12 "interest" amounts (get the other 8 yourself!) and you'll get 2.73.