Multiple Choice
When dealing with a loan that is to be repaid in equal periodic payments, which time value of money equation is most appropriate to determine the payment amount?
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10. Time Value of Money
Time Value of Money Equations
Multiple Choice
2. Why does the amount of interest you pay on a loan typically decrease every month when making regular payments?
A
Because the lender applies more of each payment to interest as time goes on.
B
Because the outstanding principal balance decreases with each payment, resulting in less interest being charged on a smaller amount.
C
Because the interest rate decreases over the life of the loan.
D
Because the total loan amount increases, reducing the interest portion.
Verified step by step guidance1
Understand the concept of loan amortization: When you take out a loan, the lender calculates the total amount of interest based on the principal balance and the interest rate. As you make regular payments, the principal balance decreases over time.
Recognize how interest is calculated: Interest is typically calculated as a percentage of the outstanding principal balance. This means that as the principal balance decreases, the amount of interest charged on the remaining balance also decreases.
Break down the payment structure: Loan payments are usually divided into two parts—interest and principal. Early in the loan term, a larger portion of the payment goes toward interest, while later payments allocate more toward reducing the principal.
Understand the impact of decreasing principal: With each payment, the principal balance decreases, which reduces the base amount on which interest is calculated. This is why the interest portion of the payment decreases over time.
Clarify the misconception: The interest rate does not change over the life of the loan (unless it's a variable-rate loan). The decrease in interest paid is solely due to the reduction in the principal balance, not because the interest rate decreases or the total loan amount increases.
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The amount of interest paid is normally calculated on which of the following?
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Multiple Choice
The taxable portion of each annuity payment is calculated using which method?
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