Cost of Borrowing

Question 1

What is interest?

Answer 1

• The cost of borrowing
• The reward for saving

Question 2

What is quoted or advertised rate?

Answer 2

• This is normally the interest rate lenders advertise to customers
• By law lenders have to show this rate to customers.
• It is used so that customers can easily compare financial products.
• It shows the cost of borrowing if interest is charged on an annual bias.

Question 3

What is (EAR) Effective Annual Rate?

Answer 3

• Takes the quoted/ advertises rate and adjusts it to take into account the frequency of interest charges.
• Often, interest is not charged once a year but on a quarterly or monthly basis.
• The EAR is higher than the quoted rate

Question 4

How do you calculate the EAR from the quoted rate of interest?

Answer 4

• Take the quoted rate and divide it by frequency with which interest is charged.
• Turn the interest rate into a decimal
• Add 1 to the decimal
• Multiply this number to the power of the number of times interest is charged.
  -Minus the one and turn the number back into a percentage.