Compound versus accrued interest?

[mchris15]

How to do you know whether the loan schedule should use the formula for compounding interest (loan balance outstanding * ((1+interest rate)^(days/365)-1) instead of accruing interest? (principal only outstanding*interest rate*days/365)?

[JakobLavrod]

The important factor is how often payment is being made. If yearly payment is made, then after 1 year, the outstanding balance on an initial nominal of 1 will be 1 + interest rate. If payments are being made quarterly, after 1 quarter, the balance will be 1 + interest rate/4, annualized, that is (1 + interest rate/4)^4. If you have daily payments, (1 + interest rate / 365)^365 is the annualized number. Key here is that the interest rate referenced here is the nominal rate that is charged to the customer. You could also compute an effective rate EIR so that it will be equal to the rate that the customer would get if they only paid yearly, so in the case of quarterly payments, 1 + EIR = (1 + interest rate/4)^4. But the advice is to always start from the contract itself, and see when payments are being made.

[DJP]

Hi mchris15,

That will be defined in the contract.