Interest is the price you charge for the money you lend. The way you choose to calculate and apply interest will affect your revenue and your competitiveness.
LoanCirrus manages interest rates at the loan product level. When you create a loan product you define how interest is to be charged.
FLAT v. DECLINING
The first thing to decide is whether your loan product will use:
a) A FLAT interest rate method - The interest amount remains constant (flat) even as the outstanding principal decreases with repayments. This is also referred to as ADD ON interest in some markets.
b) A DECLINING interest method (sometimes called REDUCING BALANCE) - The interest amount is adjusted as the outstanding principal declines or is reduced. This means that the interest amount will vary for each installment.
WHEN TO START CALCULATING
Interest is calculated daily.
However, you can instruct LoanCirrus to either start calculating interest on disbursement OR on first repayment. This is an important consideration that can affect revenues.
Interest accrual is basically the frequency that you charge the interest rate. Simple interest is charged annually. You loan $100,000 at 12% and you charge it once. Total Interest is $1,200 or 12% of $100,000. But what happens if you charge the interest each month? Here, things get a little trickier.
The first number here that’s important is the APR, which is the truly important number when it comes to debts (and interest). Every debt and every savings account you come across will have an APR that describes how much interest pays into that account over the course of a year. (As we’ll see, that number only tells you part of the story, but it’s still vital.)
If you’re accruing interest monthly, you have to divide that APR into 12 equal parts – one for each month. So, let’s keep looking at that $100,000 debt from the earlier example, the one with the 12% APR. If we divide that 12% into 12 equal parts, we get 1% per month.
So, in January, you do the first accrual. You take $100,000, multiply it by 1% (giving you $1,000), and add it back to the balance, giving you $101,000.
In February, you do it again. You take the new balance, $101,000, multiply it by 1% (giving you $1,010), and add it back to the balance, giving a new balance of $102,010.
In March, you do it again. You take the new balance of $102,010, multiply it by 1% (giving you $1,020.10), and add it back to the balance, giving a new balance of $103,030.10.
You get the idea. So, let’s skip ahead to December.
In December, you would take your balance of $111,566.83, multiply it by 1% (giving you $1,115.67), and add it back to the balance, giving a new balance of $112,682.50.
Here’s the thing to notice. You have the same starting balance – $100,000 – and the same APR – 12% – but if you accrue it annually, you have an ending balance of $112,000. If you accrue it monthly, you have an ending balance of $112,682.50.
The difference in how the money is accrued makes a difference of $682.50.
Here’s where APY becomes important. In this case, the APY is 12.6825%. If you take the original balance of $100,000 and multiply it by the APY, you’ll get $12,682.50. Add that back to the balance and you get $112,682.50 … the balance you get when you accrue monthly.
Accrued Interest can be written off when a customer wishes to Pay Off a loan prematurely. This option can be found on the Pay Off feature.