APMacro P2: PF Figuring Interest

Interest Rate
Credit isn’t free. The price of credit is called the interest rate, and total interest paid is known as the finance charge. The finance charge is usually stated in dollars, but sometimes it is stated as a percentage of the loan. When stated as a percentage of the loan, it is another way to refer to the interest rate. 

The Truth in Lending Law makes comparing credit costs fairly simple. This federal law requires that all lenders state their finance charges and interest rates in the same way. This rate is called the annual percentage rate, or APR. An APR is the rate you pay in a single year on the money you borrow.

Every loan must also state the finance charge. When stated in dollars, the finance charge is the total dollar amount of interest and other fees you must pay on the loan. The amount you borrow is called the principal of the loan. You pay back the principal plus the finance charge. The finance charge depends on the interest rate, the principal, the loan fees, and the length of the loan. The higher the APR and the longer the period of the loan, the higher the finance charge.

The basic formula for figuring out interest: FC = PRT

  • FC: Finance charge or total interest
  • P: Principal
  • R: Interest Rate (an add-on rate, expressed in decimal form)
  • T: Time (in years)

In this formula, the rate is an add-on rate with one payment of principal. An add-on rate is a simplified way to compute total interest on a loan. It is calculated by simply determining the total interest that is payable on the full principal. This amount is then added to the amount of the principal to determine the total amount owed. Note that this is different from calculating payments according to APR procedures.

This formula assumes that the principal or amount of loan and the interest are paid in one lump sum at the maturity date or end of loan period. For example, if you borrowed $2,000 at a 12 percent add-on rate for two years, the interest would be $480 ($480 = $2,000 x .12 x 2). The amount of $2,480 (interest and principal) would be repaid at the end of two years.



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