CHAPTER 3 MINI-CASES

HOW MUCH DOES IT COST? THREE MINI-CASES*

This draft: November 12, 2010

Overview to mini-cases1

Understanding The LawWhen Should A Lender Disclose The Annual Percentage Rate (APR)

and What Is It?.................................................................................................................................3

Mini-case 1: MortgageRatesUSA.com...........................................................................................5

Mini-case 2: Columbia National gives a loan.................................................................................6

Mini-Case 3: Oregon Telco Credit Union.......................................................................................8

Overview to mini-cases

One of the best ways to understand interest calculations is to redo other peoples

examples. In mini-cases we present a number of examples from the Web. In each case students

are asked to redo the calculations.

In all of these cases the terminology annual percentage rate (APR) is used. The concept

of APR was designed to make it easier for borrowers to compare the cost of loans from different

** This is a preliminary draft of a case to accompany Principles of Finance with Excel, 2nd

edition. 2011 Simon Benninga (simon@simonbenninga.com ).

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sources. The Federal Truth in Lending Act requires lenders to disclose the APR, but

unfortunately the Act does not specify how the APR is to be calculated.

The result of this ambiguity is that there are many concepts of APR. 1 The message of

Chapter 3 and of these cases is that the APR concept is not as meaningful as the effective annual

interest rate (EAIR) for determining the actual cost of financing, the annualized internal rate of

return of the loan payments. Exhibit 1 shows a quote from the Cornell University Law Website

which states the requirements for use of APR.

1 The Columbus State University Visa example in Chapter 3 (page 95) is also an illustration of

this.

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Exhibit 1: Understanding The LawWhen Should A Lender Disclose The

Annual Percentage Rate (APR) and What Is It?

Source: Cornell Law website

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These mini-cases make two points:

1. APR is not a uniform concept! There are at least three concepts of APR that crop up

regularly:

APR = Periodic percentage rate * number periods per year. An example is the Columbus

State University credit card discussed in on page 95: There a daily interest rate of

0.07668% is translated to an APR of 27.99% = 0.0007668 * 365. As we show in

Section ??? the EAIR is (1.0007668)365 = 32.268%

In many mortgage calculations APR = 12*monthly IRR. See Mini-case 1 below.

Sometimes (as Mini-case 3), the APR calculated is actually the EAIR.

2. The only interest rate that can be used to compare alternative costs of financing is the

effective annual interest rate (EAIR).

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Mini-case 1: MortgageRatesUSA.com

In the questions below, assume that you have taken a $100,000, 30-year mortgage with monthly

payments:

1. What is the monthly payment on the mortgage?

2. What is the monthly interest rate that sets the NPV of the 360 monthly payments = 0? [To

answer this question you should use Excels NPV function and Goal Seek.]

3. What is the effective annual interest rate on the mortgage? (Hint: take

1 monthly rate
12
1
).

4. How did the authors of the Web page arrive at 8.107% APR?

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Mini-case 2: Columbia National gives a loan

The web page below gives a good definition of APR (and also shows why this concept is NOT a

good finance concept!).

This mini-case has 2 paragraphs.

1. In paragraph 1: Calculate:

The monthly payments on the mortgage

The monthly IRR (use PMT )

Show that the APR in the paragraph = monthly IRR * 12

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 Compute the EAIR

2. In paragraph 2:

Compute the monthly IRR, APR and EAIR for both loans (word of warning: the

numbers on the Web page are slightly off).

Which loan is preferable?

3. The Web page claims that loan 2 is preferable because the total payments over 60 months on

this loan are lower than that on loan 1. Show that this is wrong.

4. Despite its higher initial cost, you might think that loan 2 is preferable because it has a higher

initial loan amount. Calculate how much you would need to borrow with loan 1 in order to

receive a net amount of $100,000 (you can do this calculation using Goal Seek, but it can also be

done using the formulas of Chapter 2). Doing it this way, show that Loan 1 is preferable.

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Mini-Case 3: Oregon Telco Credit Union

The Oregon Telco Credit Union has the following Web page:

Show that the Oregon Telco Credit Unions annual percentage rate (APR) is actually the effective

annual interest rate (EAIR).

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