Interest Calculations in General
If payments are made on the date the amortization schedule calls for the schedule is simple and straight forward. Late or early payments and extra payments or prepayments in between regularly scheduled payments present many interest calculation scenarios. These variations have not been properly addressed in Canada or the USA and have resulted in considerable confusion and litigation. This topic is going to be treated in depth on this site in the future. It has been said that “sunshine is the best disinfectant”. If enough light is shed on these matters, lenders that use confusing and convoluted interest calculation jargon will be exposed!
Here is an example that was recently (08/01/2002) brought to my attention. Its an example of good news and bad news. The message below in quotes appeared at the bottom of an invoice sent to a customer.
“Interest accrues daily on overdue accounts (commencing 35 days after a bill is mailed) and is calculated and compounded monthly for an effective annual interest rate of 19.56%”
The good news is that the customer is made aware of the effective interest rate (EIR) is 19.56%.
If the customer owed $100 and the bill was unpaid for exactly one year, the amount owing would be $100 x 1.1956 = $119.56
The bad news is the confusing terminology. Effective interest rates (EIR) are always assumed to be on a yearly basis in financial circles. By referring to it as an effective annual interest rate is too wordy and implies there are effective interest rates for lesser periods of time. There is no need to mention the word annual. If the interest accrues daily why not compound it daily and use a lower interest rate so that the EIR is the same or equivalent to 19.56%? The extra wordage of “compounded monthly” is also confusing to a novice.
This invoice should have contained a detailed and simple example of how the interest would be calculated. It appears that the person drawing up this form was not familiar with the mathematics of interest calculations and proper use of terms. In fact it would have been simpler to use exact simple interest for the exact number of days until the invoice was paid.
WHAT'S COMING DOWN THE ROAD
Soon you will be able to purchase and download an ebook entitled, “Interest Calculations” by Ron Cirotto that will lead the novice by the hand and explain in detail Interest calculations and in particular how they relate to and effect mortgages, loans and leases.
Interest Calculations, by Ron Cirotto
When you borrow money (a loan) an interest clock starts ticking. The longer you wait to repay the loan the larger the interest costs. Charging interest for the use of money is not a recent concept. In 450 BC, Nehemiah, the governor of Jerusalem, had to revise the usury laws (charging of excessive interest).
There are many ways to calculate interest. Below are a few of the main methods;
Exact Simple Interest