How To Differentiate Between Interest Determining Methods?
Published on: Sat, Jan 30, 2010
Classified as: Personal Finance
If you find yourself deep in thought before going to get a car loan approval, this is not an uncommon situation at all. After all, a car loan is all about getting best interest rates and manageable payment plans. But at the eleventh hour you might just be concerned about one thing: Interest Rate.
Yes, indeed, it is true. People getting car loan are usually most concerned about the interest rates they may get. ‘Interest’, essentially, is the extra amount of money you will be paying to your lender at the end of the day, in addition to the amount of loan. So what determines this amount of money?
Other than the terms provided by your lender, interest that you pay primarily depends upon the way your interest is calculated. There are three common ways lenders go about this: they may calculate the interest amount by using either the method of Simple Interest, Compound Interest or Rule of 78.
An insight into the mechanisms of the calculations under these three methods would give you some advantage when you are selecting a particular loan out of the many choices that you have.
Interest Calculated by ‘Simple Interest’ Method:
Just as the name suggest, this method is the simplest among all. It is not only simple as with the respect of its calculation but also with the respect of the amount of interest it determines.
This is basically a method whereby interest is calculated by applying interest rate on the principle in every period. Unlike the other two methods that I’ll be touching upon, this one gives the lowest amount of interest. You may find this method used with the loans which are given out on short term basis usually.
‘Compound Interest’ Method:
This particular methodology of determining interest over the loan you take may prove to be a little perplexing. Not only the method of calculation seems difficult, the amount of interest may also be in excess to that calculated in the prior method. Fundamentally, this method includes all the previous accumulated interest in the principle before the interest rate is applied to it, for calculating interest in any specific period.
Therefore understandably the cumulative amount of interest at the end of the day, under this method, will come out to be relatively greater.
‘Rule of 78’: Another Method
This method is on other common one used out there for the calculation of interest. It, basically, goes by the principle that more interest should be charged to the earlier periods than to the later periods. This is meant to penalize those who tend to pay back interest earlier than it is scheduled to be paid.
This method involves calculating interest as per the weights allocated to each specific period. Allocation of weights occur on a reverse basis, that is to say, earlier periods are assigned bigger weights and later periods, lesser. Under this rule, essentially, if someone plans to pay back loan exactly in the scheduled amount of time, he’ll end up paying exactly as much amount of interest as he will otherwise pay under ‘Simple Interest’ method.
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