interest-rates on S Anand

Difference between interest rate and APR

Wed, 10 Jan 2007 12:00:00 +0000

When I moved to the UK, I was surprised to see mortgages advertised for 4.9%. ICICI Bank's HiSAVE account was offering 5.15% interest on savings. So if I borrowed at 4.9% and invested at 5.15%, I can make money for nothing!

The catch, of course, is that the mortgage was 4.9% APR. Annual Percentage Rate is the total interest you pay on the initial amount you borrow, divided by the number of years. This has nothing to do with the Internal Rate of Return, or the regular interest rate we know of.

APR is supposed to make it easy to compare loans by including the upfront fixed costs, this way you'll what mortgage financing option is the right one for you. Personally, I still prefer the IRR calculation.

Here's an example. Say you take a 10-year loan for 100,000 at an interest rate (IRR) of 10%, paid annually. Say in the first year you repay 10,000 of that 100,000. But you'd also have to repay the interest: 10% of 100,000, which is 10,000. So your first year payment is 10,000 + 10,000 = 20,000.

Next year, you repay another 10,000 of the loan, plus interest. But the interest is now on 90,000, since you already repaid 10,000. So your payment is 19,000. The next year, it goes down to 18,000, and so on until in the last year, you have a balance of 10,000, which you pay back with 1,000 interest.

Year	Principal	You repay	Interest	Total
1	100000	10000	10000	20000
2	90000	10000	9000	19000
3	80000	10000	8000	18000
4	70000	10000	7000	17000
5	60000	10000	6000	16000
6	50000	10000	5000	15000
7	40000	10000	4000	14000
8	30000	10000	3000	13000
9	20000	10000	2000	12000
10	10000	10000	1000	11000
Total	-	-	55000	155000

This means you're paying an interest of 55,000 across 10 years, on a loan of 100,000. So your annual percentage rate (APR) is 5.5%. Get it?

So really, you're not paying an interest of 5.5%. You're paying 10%. But because you're paying back the loan, your interest amount comes down. The APR makes it look like you're paying less.

As a rule of thumb, the real interest rate is a little less than twice the APR.

Comments

Indian Recipes 10 Jan 2007 6:02 pm: Excellent explanation. This cannot have been explained in any more simpler terms/ exmaple. Thanks.
Amit 17 Jan 2007 4:11 pm: Best definition of APR and Interest rate. Thanks a lot
Chitra 21 Mar 2007 6:21 pm: Anand, what’s AER?
S Anand 21 Mar 2007 7:58 pm: AER’s the same as APR. It means Annual Effective Rate.
Wajahat Basharat 10 Jan 2007 12:00 pm: I always got confused in IRR and APR. but this explanation is marvelous. thank you very much for this information. Cheers
B a l a 11 Sep 2008 3:05 pm: Thanks !! Nice and Clear. It can avoid some haste decisions by just looking at the APR. Till now I wasn’t sure of the difference.
Wayne 7 Mar 2009 11:47 pm: Hi, I’m investigating a case of “loan sharking.” I can calculate the simple interest charged on these loan, but I need to come up with the APR of the loans to prove “loan sharking.” All of the simple APR calculating programs I can find are based on on the term of the loan being in years, not months. Can you look at these examples and provide me with a formula to calculate the appropriate APR’s.
1. BH paid W only $425, between Aug 4, 2007 and Jan 4, 2009, on her $1,200 loan. W’s records show she owes him $1,515.52 as of Jan 4, 2009, and he has charged her $635 for “late fees” in addition to the remainder of her loan amount.
2. YH paid W only $517.88, between July 11, 2007 and Dec 27, 2008, on her $1,500 loan. W’s records show she owes him $1,610.92 as of Dec 27, 2008, and he has charged her $450 for “late fees” in addition to the remainder of her loan amount.
3. AH paid W $1009, between Aug 8, 2007 and Jan 17, 2009, on her $1,220 loan. W’s records show she owes him $806.16 as of Jan 17, 2009, and he has charged her $480 for “late fees” in addition to the remainder of her loan amount.
4. CH paid W $6,936.04, between Aug 25, 2007 and Mar 25, 2008, on her $5,550 loan. W’s records show she owes him a zero balance as of Mar 25, 2008. He charged her $155 for “late fees” on her loan amount, but “waive(d)” the final payment of $155.06.
5. DA paid W $8,269.76, between Jun 22, 2008 and Oct 6, 2008, on a $6,600 loan. W’s records shows a zero balance as of Oct 6, 2008. W charged $150 for “late fees” on the loan amount, but waived the final payment of $219.79 as a “write of for early payoff.”
Crossing 19 Jul 2011 6:47 pm: I think the above example is wrong based on the description in FSA’s MCOB 10. APR is effectively an IRR assuming no early repayment and penalty fees. Hence, in your above numerical example, APR will be 10.0%.

Psychological framing in behavioral economics

Fri, 12 May 2006 12:00:00 +0000

People act on the spur of the moment, most of the time. So, as you can see from this example below, psychology can be more important than economics.

Senthil Mullainathan worked with a bank in South Africa that wanted to make more loans. A neoclassical economist would have offered simple counsel: lower the interest rate, and people will borrow more. Instead, the bank chose to investigate some contextual factors in the process of making its offer. It mailed letters to 70,000 previous borrowers saying, “Congratulations! You’re eligible for a special interest rate on a new loan.” But the interest rate was randomized on the letters: some got a low rate, others a high one. “It was done like a randomized clinical trial of a drug,” Mullainathan explains.

The bank also randomized several aspects of the letter. In one corner there was a photo-varied by gender and race-of a bank employee. Different types of tables, some simple, others complex, showed examples of loans. Some letters offered a chance to win a cell phone in a lottery if the customer came in to inquire about a loan. Some had deadlines. Randomizing these elements allowed Mullainathan to evaluate the effect of psychological factors as opposed to the things that economists care about, i.e., interest rates-and to quantify their effect on response in basis points.

“What we found stunned me,” he says. “We found that any one of these things had an effect equal to one to five percentage points of interest! A woman’s photo instead of a man’s increased demand among men by as much as dropping the interest rate five points!

Comments

Lesson 1: What Is Behavioral Economics? « The Innovative Economics Initiative 15 Nov 2011 6:25 am (pingback): […] (the background). This concept, presenting the same object in different formats, is known as framing, and is one of the most well-known biases used by Behavioral Economists. For example, if I asked […]
bala 8 May 2012 2:37 pm: i have written a tamil book on behavioral economics it can be downloaded from the link www.scribd.com/doc/88128740 the book குகைமனிதனும் கோடிரூபாயும் நூல் 1000 வாசகர்களுக்கு மேல் வாசிக்கப்பட்டுள்ளது may you go through it and give your comments. and forward to your friends if it is good thank you bala

Demand draft fees

Tue, 21 Mar 2006 12:00:00 +0000

Once, we were looking at whether banks made money on demand drafts (DDs).

DDs are costly. 90% of a bank’s costs are people-related, and it takes a fair bit of time (hence people) to process DDs. If you pay for DDs in cash, it costs even more because the teller has to count the notes.

To recover this cost, banks charge a fee. The fee increases with the size of the DD. A DD for Rs 10,000 may cost Rs 50, while one for Rs 100,000 may cost Rs 200.

But apart from the fee, banks also earn float on the DD. Let’s say you go to a bank, pay Rs 100,000, and take a DD. You mail the DD to someone, who cashes the DD three days later. The bank has your Rs 100,000 for 3 days, and earns the overnight interest rate at around 5%, netting Rs 41 in the process. This float is significant for large DDs.

Our client bank was making a small loss on DDs. Every DD less than Rs 50,000 caused a loss (even after including float). And 3 out of every DDs was smaller than Rs 50,000.

Then we had this bright idea: let’s lower fee for large DDs, attract of them, and get more float income. DDs above Rs 50,000 are profitable. So big DDs are worth going after. 80% of the float income comes from the top 22% of DDs. So surely, the big DDs are worth going after. Float income increases forever, whereas fee income is capped. So big DDs could absolutely be terrific.

We were thrilled. Here was a revolutionary counter-intuitive idea: have lower charges for DDs to get more money. We kept talking about it to our client. But at the end, we didn’t suggest it. It got left behind the conventional idea of increasing the fee for small DDs.

We were a bit disappointed, and kept cursing the conservatism of public sector banks. Goes to show how the bright young consultants can be naive. For, as it later turned out, the bulk of DD revenues is really fee income (88%), not float income. Had we lowered the fee income, there’s would’ve been no chance for the float income to make up for it.

Why did we miss that? A couple of reasons. The simple one was, though the float income increases forever, doesn’t beat fee income until the DD is about Rs 2 crores. DDs typically stay with you for a few days, and you can’t earn much interest on that.

The other reason was subtler. We had assumed that the float income for a DD of Rs 100,000 is 100 times that of the DD income for Rs 1,000. But the float income does not increase linearly! Someone who gets a DD for Rs 1,000 doesn’t mind waiting a bit to present it, but someone who gets a DD for a lakh would walk to the bank the very same day. The chart below shows how long customers wait to cash DDs. The X-axis is the size of the DD. The Y-axis is the number of days they wait. It shows a clear diminishing trend.

Lesson: Conservative bankers might make more money not listening to hotshot consultants.

Comments

Shreyas 27 Mar 2006 10:22 am: Very insightful case study! But did increasing the fees for smaller DDs help boost the profits? Did it not reduce the number of customers taking DDs?
S Anand 27 Mar 2006 12:08 pm: We didn’t measure that. But even if it reduced the number of customers it would have (in the long run) increased profits, since they were losing money on every small DD sold! They would be able to shift someone from the DD section elsewhere, and avoid having to recruit a new person.
ronnie 21 Mar 2006 12:00 pm: Hello i like to join and i wish to be a member of demand draft so mail me pls
Walter Atkinson 21 Mar 2006 12:00 pm: I was looking to this information and was helpful…ok Best Regards Walter http://www.surveynew.com Premier Paid Survey Company.
ritu raj 17 Nov 2008 7:32 am: what doc need to be presented to the bank for the dd of 375000 to be paid in cash?
uss 8 Jul 2011 6:42 pm: but there is no dd charges for current account in private bank.ll it cost loss to the bank
Vignesh 23 Oct 2012 9:22 am: Beautifully written. I liked your articulation.
pradeep kumar 16 Jun 2015 3:29 am: This article is very nice and informative. Came here while searching for something related and found it very informative. Thank you very much.
Donga Satyanarayana 28 Feb 2017 8:20 am: Some private banks are fee DD charges allowed with simple amount deposit. But our Bank is world wise national Bank . This Bank is some lakhs of crores rotining services. Better to allow free DD charges atleast a limited amount. Thanking you

Greenspans defence

Mon, 09 Sep 2002 12:00:00 +0000

Greenspan’s defence. On why he couldn’t have raised interest rates earlier and prevented the bubble.

Moody downgrading

Fri, 10 Aug 2001 12:00:00 +0000

If nothing else, the Moody downgrading and S & P downgrading mean a further slowdown in India, despite any rate cuts.

Fed lowers interest rates

Thu, 04 Jan 2001 12:00:00 +0000

The Fed lowers interest rates! Certainly hadn’t expected it till the end of the month. Obviously, since this is the first time they changed rates in-between policy meetings. The market was caught short too. Anyway, the NASDAQ has shot up. IT stocks in India are following.

Fed will lower rates in Jan 2001

Tue, 26 Dec 2000 12:00:00 +0000

You can use the Fed Futures to get the market’s estimate of whether the Federal Reserve will lower interest rates. My guess, based on the numbers is that it will happen in late January 2001. Buy up stocks before then!

Time to buy tech stocks

Mon, 25 Dec 2000 12:00:00 +0000

My guess is, with the US market slowdown, the Fed will reduce interest rates, software stocks will pickup again and live happily ever after. Time to buy IT, not sell!