Question

Rochelle needed to borrow $3,000 for three months in order to pay for college expenses while waiting for her scholarship to arrive. After Rochelle filled out the loan application, the loan officer at the bank asked her if she would like to pay the interest upfront or at the maturity of the note. He went on to explain that it didn’t make a difference, but he preferred that she pay it upfront because it would make his paperwork easier. He also told Rochelle that the interest rate and amount would be the same. Rochelle agreed, signed the three-month, 8%, discounted note and left with a check for $2,940.

Did the loan officer offer Rochelle an acceptable explanation of the interest rate? Justify your answer and discuss some common situations where the average person might misunderstand interest rate quotations.

Answer 1

the loan officer at the bank has told Rochelle that it didnt make any difference if she pay the interest upfront or at the maturity of the note.

First of all we need to understand that $60 interest accrues at the end of the Loan period and not at the start of the period. So interest wasnt due till end of three months. Though $60 at the start or end may seem the same. But the present value of 1 dollar is always gonna be more than after three months. This is called time value of money.  Here by paying the $60 interest at the start of the Loan Rochelle has lost on interest she could have earned on $ 60 if she deposited it somewhere else.Therefore, the Loan officer didnot offer Rochelle the correct Advice.

Some of the common situations where the average person might misunderstand interest rate quotations are

1. Frequency of comunding: One should always check how frequently the Loan will be getting compounded because that will effect the interest. For example a loan of $1000 at 10% interest rate compunded annually will make your interest cost at 100. where as same loan compounded monthly will get your interest cost at 104.71

2. Interest rate fixed or not: Many Times interest rates are linked to external Benchmarks and one should choose carefully whether fixed interest rate or external benchmark rates suits them.

3. Fees charged: Banks charges different fees when you take loan some of them are processing fee or upfront fee or origination fee. while evaluating a loan these fees must be taken into account for the cost of debt.