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.