tailieunhanh - CALCULATING INTEREST RATES: A READING PREPARED

Some of the responsibility for ensuring a competitive marketplace must be placed on borrowers themselves, since knowledgeable, informed borrowers help to foster competition in credit markets. When consumers do not know or cannot compare rates being charged by various lenders, each lender has more freedom to charge any rate — fair or unfair. A high level of borrower awareness can create a natural protection from unreasonable interest rates, in lieu of the external constraint of a usury ceiling. 1 Economic theory suggests that interest rates are best determined by the marketplace rather than by legislative mandate. In the case of credit cards, however, some felt in the early 1990s. | Calculating interest rates A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction 2. Annual percentage rate 3. Effective annual rate 1. Introduction The basis of the time value of money is that an investor is compensated for the time value of money and risk. Situations arise often in which we wish to determine the interest rate that is implied from an advertised or stated rate. There are also cases in which we wish to determine the rate of interest implied from a set of payments in a loan arrangement. 2. The annual percentage rate A common problem in finance is comparing alternative financing or investment opportunities when the interest rates are specified in a way that makes it difficult to compare terms. One lending source may offer terms that specify 91 4 percent annual interest with interest compounded annually whereas another lending source may offer terms of 9 percent interest with interest compounded continuously. How do you begin to compare these rates to determine which is a lower cost of borrowing Ideally we would like to translate these interest rates into some comparable form. One obvious way to represent rates stated in various time intervals on a common basis is to express them in the same unit of time -- so we annualize them. The annualized rate is the product of the stated rate of interest per compounding period and the number of compounding periods in a year. Let i be the rate of interest per period and let n be the number of compounding periods in a year. The annualized rate also referred to as the nominal interest rate or the annual percentage rate APR is APR i x n where i is the rate per compounding period and n is the number of compound periods in a year. The Truth in Lending Act requires lenders to disclose the annual percentage rate on consumer As you will see however the annual percentage rate ignores compounding and therefore 1 15 . 1601-1666j Federal Reserve System Regulation Z 1968. Calculating interest .

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