{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Web Appendix 16B - 19819_16Bw_p1-3.qxd 10:41 AM Page 16B-1...

Info iconThis preview shows pages 1–2. Sign up to view the full content.

View Full Document Right Arrow Icon
16B-1 Chapter 16 discussed two common methods of calculating bank interest charges: regular, or simple, interest and add-on interest. However, depending on the nature of the lender and the borrower’s creditworthiness, other loan interest arrangements may be used. This Web Appendix outlines two such loan interest structures: discount interest and compen- sating balances. Discount Interest In a discount interest loan, the bank deducts the interest in advance ( discounts the loan). Thus, the borrower receives less than the face value of the loan. On a one-year, $10,000 loan with a 12 percent (nominal) rate, discount basis, the interest is $10,000(0.12) $1,200. Therefore, the borrower obtains the use of only $10,000 $1,200 $8,800. If the loan were for less than a year, the interest charge (the discount) would be lower; in our example, it would be $600 if the loan were for six months, hence the amount received would be $9,400. The effective rate on a discount loan is always higher than the rate on an otherwise similar simple interest loan. To illustrate, consider the situation for a one-year, $10,000 loan with a 12 percent nominal annual rate, discount basis. Discount interest, paid annually: With a financial calculator, enter N 1, PV 8800, PMT 0, and FV 10000, and then press I/YR to get the effective cost of the loan, 13.64 percent. 1 Now, consider the situation for a three-month $10,000 loan with a 12 percent nominal annual rate, discount basis. Discount interest, one quarter: Enter N 1, PV 9700, PMT 0, and FV 10000, and then press I/YR to find the periodic rate, 3.092784 percent per quarter, which corresponds to an effective annual rate of 12.96 percent. Thus, shortening the period of a discount loan lowers the effective rate of interest. This occurs because there is a delay in paying interest relative to the longer-term discount loan ($300 paid each quarter rather than $1,200 paid up front).
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 2
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}