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You have embarked on an exciting journey! Congratulations and best wishes. I'm real excited for you
because you are now a member of a very special comunity! The Entrepreneurial comunity!
How is interest Computed?
It's not just how interest is computed but also why you should be aware of it. It is
something you should know about.
So how is interest computed?
First, straight interest!
Straight interest is the easiest to understand and the best to use if you are a
borrower. Here's why:
When a lender offers straight interest, you borrow a specific amount and you pay
a specific interest. Straight forward. You know exactly what your full payment is
going to be.
For
instance, you borrow $1,000.00 for one year at the rate of 17% year. Your payments will be
calculated as follows.
Amount borrowed + interest amount / term. Or, $1000+(1000*.17)/12 which means that your
payment will come to: 1000+170/12 equals $97.50 per month to pay off your loan.
This is as simple as it gets. You know where you stand and your lender knows where he stands
and the only difference will be the penalties if you pay late.
Contrast this with the compound interest.
Then, compound interest!
Compound interest is usually calculated on a daily basis and is added to the amount borrowed
to calculate the balance owed. The payment amount can stay the same but the term will vary
to take care of the interest that is being added as you continue making the payments.
This is why credit card debt is so difficult to get rid of. Specially if you are making the
minimum payment only.
Let me explain how this works.
For
instance, you borrow the same $1,000.00 for one year at the rate of 17% year. The difference
is that your interest is compounded on a daily basis. Your payment is still the same, $97.50.
This is really immaterial to the loan. You can use any payment amount you want.
$1,000 @ 17% interest gives a monthly interest amount of $13.17. So far so good.
This is where it gets more complicated.
Compounding
Here's how the payment is applied. First, the
interest is deducted from the amount of the payment: (97.5013.17)
so the payment ends up as just $84.33. That is applied to your
loan.
Now the cycle begins again. Your principal was $1000 less payment of $84.33
equals the new balance of $915.67. But that is not what your new loan balance is.
The actual loan balance is going to be $915.67 plus the monthly interest ($13.17) for the actual
balance of $928.84. The reason for this is that the interest is calculated from the beginning
of the period. So now the process starts again.
Starting with a loan balance of $928.84 less
payment of (97.50 less interest 12.23) equals the new balance of
$928.84$85.27=$843.57.
And so on and so forth. Eventually you will pay it off but you will end up paying about $184in interest as opposed to the $170 on a straight interest loan. That is, provided you didn't miss a payment nor tried to get a payment forgiven. Then, it could be much higher.
It's not Much of a Difference?
This
should be something you understand very well if you are looking to borrow money because the
cost of borrowing could easily turn a profitable deal into a losing deal. On a $10,000 deal or
even $100,000 these amounts will become real significant.
The Rule of 72
If you haven't heard of this before you need to
get to know this rule real well. The rule of 72 simply stated means
that your loan (borrowed or money lent) doubles as many times as the
interest rate goes into 72. For instance, for an interest rate of 6%
your loan doubles every 12 periods. (72 divided by 6 equals
12).
If an annualized loan, it will be every 12 payments.
Credit cards benefit from this because we tend to carry balances from year to year and
the interest rate is fairly high that they really don't want you to pay off the balance. The
credit card company wants you to carry a balance. Do the math and you will know why.
Final Thoughts
There's more to this but the information here
should help you get started realizing how the cost of borrowing
affects your bottom line. There is more to this but this should wet
your appetite.
If you would like more information on this or any other items here send me an email
loans@startbusinessloans.comwith your questions
