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Formulas and Approaches Used to Calculate True Pricing

Published on May 22, 2012

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The true price of a loan includes not only interest but other charges required by the lender as well as other techniques that influence the amount of money the client actually has and the amount of time the client has use of that money. Because of these multiple factors, as well as differences in interest calculation methods, comparing the pricing of different loan products can be very challenging. The Annual Percentage Rate (APR) is used to express the true price as a standard measure that allows for the comparison of credit charges among different loan products. The purpose of the APR is to convert the array of charges made for a loan into a simple, declining balance interest rate that would have an equivalent cost.

The textbook definition of interest is “the cost for the use of money over time”. It is essentially the rental fee for borrowing money. It is extremely important to realize that in almost all loans, the borrower has a fluid amount of money that she is renting. Only in a loan with a lump-sum payment is the pricing somewhat intelligible. In most loans, the varying loan balance makes calculation and comparison of costs very confusing. The APR is the means to convert prices to comparable terms.

To understand how to calculate the APR, it is necessary to first understand the time value of money and how to calculate the present value of future monetary amounts. This six-page document outlines the financial concepts used to calculate true pricing, including the time value of money, calculating future and present value of money, and the discount rate method of calculating APR.

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