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COMPUTING INTEREST

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INTEREST COST IS A MAJOR EXPENSE VARIES WITH INTEREST RATE VARIES WITH THE METHOD USED TO CALCULATE INTEREST

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METHODS OF CALCULATING INTEREST SIMPLE INTEREST REMAINING BALANCE ADD ON METHOD

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Simple interest Very Simple Used Primarily on Short Term Loans

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Simple Interest Example $1000 borrowed for 1 year at 5% interest $1000 x.05 = $50 interest charge $1050 to be paid back at the end of the loan

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Remaining Balance Method Used when several payments are to be made Interest is charged only on the remaining principal balance

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Remaining Balance Method $1000 borrowed for 4 years at 8% interest. The $1000 will be paid back in yearly principal installments of $250.

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YEAR 1: $ 1000 X.08 (interest rate) = $80 interest cost + $250 Principal Payment $330 Annual Payment Remaining Balance Method

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YEAR 2: $ 750 X.08 (interest rate) = $60 interest cost + $250 Principal Payment $310 Annual Payment

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Remaining Balance Method YEAR 3: $ 500 X.08 (interest rate) = $40 interest cost + $250 Principal Payment $290 Annual Payment

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Remaining Balance Method YEAR 4: $ 250 X.08 (interest rate) = $20 interest cost + $250 Principal Payment $270 Annual Payment

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Remaining Balance Method $200 Over a Four-Year Period

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ADD ON METHOD Interest charged on full principal amount for the entire life of the loan. Total interest amount is added to principal and divided into even payments

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Add On Interest Example $1000 borrowed for 4 years at 8% interest.

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Step 1: Calculate the total interest paid over the lifespan of the loan $1000 (principal amount) X.08 (interest rate) x 4 (years) $320 Interest Charge This $320 is the Interest Charge (or the total amount of interest paid over the lifespan of the loan) Add On Interest Example

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Step 2: Add the interest charge to the principal amount $1000 (principal amount) + $320 (Interest Charge) $1320 (Total amount paid) Add On Interest Example

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Step 3: Divide total amount paid by the total number of payments $1320 (total amount paid) / 4 (years) $330 Yearly Payment Notice that the total Interest Charge is $120 higher using the Add-On method than with the Simple Interest Method. Add On Interest Example

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Calculating APR (using Add-On Method) R = 2C X 100 L (P + A) Formula Key: R = Annual Percentage RateC = Total Interest Cost L = Length of Loan in YearsP = Principal Amount Borrowed A = Payment Amount Each Period

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Add On Interest Example R = 2($320) X 100 4 (1000 + 330)

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Add On Interest Example R = 12.03% This APR is MUCH higher than the original 8% interest originally charged (4.03% more)

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