Comprehension check

Now let’s summarise what we have discussed and highlight the main discoveries so far.

• Simple interest is a waste of time for proper comparisons since it does not take account of capitalised interest: compound interest does.
  
  
• Compound interest requires us to know the compounding frequency, in other words, how often interest is capitalised.
  
  
• Compound interest is charged on capital owing at the previous period.
  
  
• The true rate of interest, usually calculated annually, is an accurate way of comparing different schemes for value for money.  There is no formula for it and it needs special trial and error procedures to calculate it.
  
  
• Compounding annually but collecting monthly (like some Building Societies) is an anomalous method for repayment loan calculations, which ignores capital paid before the year end, and results in the true interest rate being larger the higher the capital element.
  
  
• Flat rates of interest can significantly understate the true rate.  Lenders using the Rule of 78 inflate the early redemption, or settlement amount.
  
  
• The nominal rate per annum is most often quoted, but you need to know the compounding frequency to determine the true rate.
  
  
• Just because lenders compound at different frequencies does not necessarily mean they are better or worse value-for-money.  The true rate, calculated over the anticipated life of the loan, is the only ultimate criteria.
  
  
• Interest-only loans do not suffer from compounding anomalies but the true rate of interest depends on the payment frequency.