Financial Management: Principles and Applications, 13/e

5.4 Making Interest Rates Comparable

Sometimes it’s difficult to determine exactly how much you are paying or earning on a loan. That’s because the loan might be quoted not as compounding annually but rather as compounding quarterly or daily. To illustrate, let’s look at two loans, one that is quoted as 8.084 percent compounded annually and one that is quoted as 7.85 percent compounded quarterly. Unfortunately, they are difficult to compare because the interest on one is compounded annually (you pay interest just once a year) but the interest on the other is compounded quarterly (you pay interest four times a year). To allow borrowers to compare rates between different lenders, the U.S. Truth-in-Lending Act requires what is known as the annual ...