Author Topic: Interest rates are backward - should use APR  (Read 110 times)

meagher79

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Interest rates are backward - should use APR
« on: May 22, 2020, 12:46:50 pm »
I just realized that the interest rate listed for loans is the total interest for the duration of the loan not the annual percentage rate (APR).  That means that 5 year loans actually have a much lower interest rate than 1 year loans!  There is no reason to ever take a shorter loan as it is.  An easy fix would be to change the label for "interest rate" to "total interest percentage" and then increase the interest on longer loans and/or decrease it for shorter loans.  Generally lenders require a higher rate for a longer loan because of the increased risk and because their money is tied up for longer.

patson

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Im not a loan expert here the rate we listed indeed in not APR

But im not sure if 5 years loan has much lower interest rate than 1 year lean? can you please explain it?

For example, if someone takes a $100 loan, and the 1 year rate is 10% and 5 year rate is 15%. I would supposed that the on 1 year term the total amount to repay is $110 and on 5 year term the total amount to replay is $115, it is true that on 5 year term, on average only $3 per year on interest, but at the same time the borrower really just getting $20 loan on average per year over 5 years period?


meagher79

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The key point is that the interest is charged each year regardless of the length of the loan.  Let's take a very simple example using "simple interest" instead of compound interest.  A $100 loan for one year at 10% interest would = $110 total repayment as you said, but a $100 loan at 10% interest for 5 years would = $150 because there is 10% interest each year. 

The situation you describe with the 5 year loan does not reflect the circumstances because the borrower gets the full $100 at the beginning and gets to use the $100 for five years (less the amount repaid over time which does reduce the interest). 

Maybe think of the 5 year loan as a series of one year loans.  Suppose on Jan. 1 of 2010, I borrow $100 to buy an airplane part.  On Jan. 1, 2011, I owe $110, but I'm not ready to repay, so I pay $10 interest, but I borrow another $100 to repay the first loan.  The first loan is done, but on Jan 1, 2012 I owe $110 for the second loan.  Again I get a new loan to repay the old one.  Each year I have to pay $10 for the use of the $100 I continue to have borrowed.  A five year loan just combines this process.  (Actually it gets more complicated depending on the repayment schedule and compounding interest.)

Try playing around with a loan calculator such as this one: https://www.calculator.net/loan-calculator.html
You are using the first option: Amortized Loan, where the principle is paid off gradually over the life of the loan.  As an example I looked at a $100,000 loan for 260 months in game.  The total repayment was $124,100 (which the game calls 24.1% interest rate, actually its the total interest)  I played around with the interest rate until I got the same total repayment and it was 8.85%

A very simple solution would be to just eliminate the shorter loans (they are a terrible deal compared to the 5yr), and change the "interest rate" label to "total interest percentage" as I suggested.  The actual 5 yr loan rate seems pretty reasonable. 

meagher79

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Re: Interest rates are backward - should use APR
« Reply #3 on: June 03, 2020, 10:47:49 am »
I will include an example from the game.  Right now I could borrow $100,000 for one year at $2,277 for 52 weeks.  This would be $18,400 in total interest and a total repayment of $118,400.  This is all good so far.  The problem is that the game calls this an 18.4% "interest rate."  In fact, the interest rate on this loan is much higher than 18.4% because the principle is being paid off over time, but the amount of interest charged doesn't go down.  I would be paying interest on money I have already paid back.  I tried to match the terms of this loan using the loan calculator and it is actually 34% APR.  Look at the top option, "Amortized Loan", at the link.  https://www.calculator.net/loan-calculator.html?cloanamount=100000&cloanterm=1&cloantermmonth=0&cinterestrate=34&ccompound=weekly&cpayback=weekly&x=70&y=22#amortized-result

On the other hand the 5 year loan overestimates interest rates for reasons I explained above.  I can also borrow $100,000 for five years at $487 for 260 weeks.  The game calls this 26.% interest, but it actually works out to be about 9.8% interest.  Again see the link and look at the top loan option "Amortized Loan."  https://www.calculator.net/loan-calculator.html?cloanamount=100000&cloanterm=5&cloantermmonth=0&cinterestrate=9.8&ccompound=weekly&cpayback=weekly&x=34&y=18#amortized-result

Conclusion:
1yr loan = 34% APR
5yr loan = 9.8% APR
The rates listed in-game are misleading.  It's not that big of a deal because the actual repayment amounts are accurate.  I love this game, and I only hope to be helpful. 

patson

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Re: Interest rates are backward - should use APR
« Reply #4 on: June 09, 2020, 11:00:29 pm »
thanks for the explanations

Do the total interest charge makes sense in this game right now?

For the interest rate i was simply doing (total interest / borrowed amount) :P

Is APR people use for mortgage too? i know people use that for car loans

meagher79

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Re: Interest rates are backward - should use APR
« Reply #5 on: June 10, 2020, 01:30:36 am »

Do the total interest charge makes sense in this game right now?

Sort of, I think the actual interest on the 5 yr loans is reasonable, but the information in the "interest rate" column is inaccurate and misleading.


Is APR people use for mortgage too? i know people use that for car loans

Yes, APR is the standard way to measure all interest rates.