Discount and Add-on Interest

The discount interest method has the following features:

1.     Interest is collected at the time the loan is granted.

2.     The entire principal is due at the end of the loan period.

If the discount interest method is used, the amount received by the borrower at the time the loan is given is less than the principal because the lender has already collected some interest in advance.

Tulad ng simple interest method, sa discount interest method, ang kabuuang halaga ay binabayaran din sa katapusan ng loan period.

For example, if you borrow PhP50,000 at 4% nominal interest for one month and the discount interest method is used, the effective interest rate he will pay is computed as follows:

Interest for one month = PhP50,000 x 4% = PhP2,000

Amount to be received by borrower for loan = PhP50,000 – PhP2,000 = PhP48,000

Average amount of principal available for borrower’s use = (PhP48,000 + PhP48,000) ÷ 2 = PhP48,000

Effective interest = PhP2,000 ÷ PhP48,000 = 4.17% per month

Mas mataas ang effective interest rate sa quoted o nominal interest rate kapag discount interest method ang ginamit dahil nabawasan kaagad ang principal na nakukuha ng borrower.  Mas maliit ang halagang napapakinabangan ng borrower mula sa pagkakautang.

On the other hand, the add-on interest method has the following features:

1.     Interest is computed based on the entire principal.

2.     The total interest to be paid is added to the principal.  This sum is then divided by the number of payments the borrower makes.

This method is commonly used in the computation of the payments for a car loan.  While interest is computed based on the entire principal, the borrower’s periodic loan payments include payments for both principal and interest.

Here is an example of a loan with add-on interest.

If you avail of a car financing loan of P300,000 at 18% interest payable in 5 years with monthly payments, loan payments will be computed this way:

Principal                                                                      P300,000

Interest for 5 years (300,000 x 18% x 5)            P270,000

———————-

Total to be paid over 5 years                                    P570,000

Divided by number of monthly payments (12mos x 5 years)            60

———————

Monthly payment                                                            P   9,500

============

Note that the PhP9,500 monthly payment has a portion for interest and a portion for principal.  This can be shown through the following breakdown:

Principal per month            (300,000 ÷ 60)                        PhP            5,000

Interest per month                (270,000 ÷ 60)                        PhP            4,500

———————

Payment per month            (570,000 ÷ 60)                        PhP            9,500

============

The principal is reduced by P5,000 with every monthly payment.  By the last monthly payment, onlyP5,000 of principal is left.

Average amount of principal available for borrower’s use = (300,000 + 5,000) ÷ 2 = 152,500

Effective interest = 270,000 ÷ 152,500 = 177% for 5 years or 35.4% p.a. (per year)

Notice how the effective interest rate is almost double the nominal or quoted rate under the add-on interest method.

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