Learning Objective # 2 Determine the effective cost of borrowing by considering the quoted rate, the number of compounding periods, the timing of interest payments & other service charges. LO#2

The Cost of Credit  Effective Annual Interest Rate depends on;  Quoted annual percentage rate  How frequently interest is compounded  Interest charged up front  Other charges such as service charges, credit-related insurance premiums, and appraisal fees LO#2

The Cost of Credit  The Annual Percentage Rate (APR) is the percentage cost of credit on a yearly basis  May be compounded more frequently  Thus Effective Annual Interest Rate may be higher than Annual Percentage Rate  The APR provides the true rate of interest for comparison with other sources of credit. This rate lets you compare like with like when shopping for rates. LO#2

Effective Annual Percentage Rate  Is calculated using the following formula  Where m equals number of times per year interest is compounded LO#2 E A R = (1 + APR/m) m - 1

Trade-Offs of Financing Choices  Term (length of loan) versus interest cost.  A longer term allows lower monthly payments, but you pay more in interest.  Lender risk versus interest rate. To reduce the lender’s risk you can...  Accept a variable interest rate.  Provide collateral to secure the loan.  Make a large down payment up front.  Have a shorter loan term. LO#2

Calculating Your Loan Payments  Fixed Rate Installment Loan  Pay off over a pre-determined period of time  Payment represents blend of interest and principal  Floating Rate Personal Line of Credit  Variable interest rate tied to lender’s prime rate  Compounded daily  Payments not fixed  At risk if interest rates rise  Takes longer to repay if only paying minimum required LO#2

Cost of Carrying Credit Card Balances  Adjusted balance method  The assessment of finance charges after payments made during the billing period have been subtracted.  Previous balance method  Method of computing finance charges that gives no credit for payments made during the billing period.  Average daily balance method  Uses a weighted average of the account balance throughout the current billing period. If you carried over a balance new purchases may be included in your average daily balance calculation. LO#2

The Cost of Credit  Expected Inflation  borrowers and lenders are concerned about the goods and services their dollars can buy - its purchasing power  inflation erodes the purchasing power of money  the expected rate of inflation is added to the interest rate charged by lenders to protect their purchasing power LO#2

The Cost of Credit  Avoid the minimum monthly payment trap  minimum monthly payment is the smallest amount you can pay and still be a cardholder in good standing  is not the total amount due  the longer you take to repay the more interest you will incur  Credit Insurance  ensures the repayment of your loan in the event of death, disability or loss of property  pays lender directly LO#2