Quiz 11 Flashcards
What is the money cost of borrowing?
the difference between the total money received from the loan and the total money paid to retire the loan
What is the money cost of borrowing composed of?
interest costs and non-interest money costs
Non-interest Money Costs included in finance change
*Service, transaction, activity or carrying charges
*Loan-fee points or finder’s fees
*Fees for investigations & credit reports
*Premiums for special insurance required as condition of loan
Non-interest money costs NOT included in Finance Charge
General home loan charges:
*Fees paid to public officials
*License, certificate of title, registration
*Taxes
*Delinquency, default, reinstatement penalities
*Title examination fees
*Preparation & Notarization of deeds, other documents
*Required escrow payments for future taxes
*Appraisal fees
Interest Rate Terminology
*Contractual interest rate (CR)
*Actuarial (periodic) interest rate (AR)
*Annual interest rate (APR)
*Effective interest rate (ER)
Contact interest rate
*The stated or nominal interest rate specified in the loan agreement
*The simplest form of interest rate presentation
*Does not account for compounding, fees, or the actual funds available to the borrower
*May not reflect the true cost of borrowing
Actuarial Interest Rate
*calculates interest based on the remaining principal balance at each payment period
*accounts for the exact timing of payments and the declining balance of the loan
*Used in fully amortizing loans where each payment reduces the principal
*Follows time value of money principles
*Forms the mathematical basis for modern finance calculations
Annual Interest Rate
*Expresses the interest rate as a yearly percentage, regardless of the compounding period
*Does not account for compounding effects within the year
Effective Interest Rate
*the true annualized cost of borrowing that accounts for all factors
*allows for meaningful comparison between different financial products
*required disclosure in many jurisdictions (often as APR)
*always equal to or higher that the stated rate (contract rate)
Key Relationships
- In a standard amortizing loan using the actuarial method with no fees, the effective rate equals the contract rate
- In add-on interest loans, the effective rate is significantly higher than the contract rate
- In discounted loans, the effective rate is higher than the discount rate
- The more frequently interest compounds, the higher the effective rate compared to the annual rate
Reasons the ER is higher than the CR
*In a standard amortizing loan, as the principal is paid down, less interest accrues
*In an add-on loan, interest is pre-calculated on the full amount regardless of principal reduction
*the borrower is essentially paying interest on money they no longer have
Discount Interest Loan
a loan where the interest is deducted from the principal amount upfront, but the borrower must repay the full principal amount. The borrower receives less than the principal amount but must repay the full principal
Interest Rates after Taxes
Both interest and some non-interest costs of borrowed capital are tax-deductible. These reduce the after-tax cash outflow of borrowing
