The borrower on an industrial type loan should realize that because the certificate is purchased on the installment plan, and because of certain other, charges that are included, the actual interest rate on the debt is twice or more the nominal rate.

There are many different ways of computing the interest rate on a debt that is being paid on the installment sys-tem. The lender will usually adopt the formula that makes the rate appear lowest. The prudent borrower will be skeptical of this figure until he has worked it out for himself.

For example, let’s suppose that you borrow $100 from a bank of the Morris Plan type. If the note is discounted at 6 per cent, plus a 2 per cent service charge, you would actually receive $92. In return you would agree to make fifty weekly payments of $2 each, or a total of $100. You might think, if you were not experienced in such matters, that you were paying 6 per cent, or at the most, 8 per cent interest.

Actually, however, you would have the use of $92 for one week; of $90 for one week; of $88 for one week, and so on, which is equal to an average unpaid balance of $41.58. You are really paying $8 for the use of $41.58 for the year, or at the simple interest rate of 19.2 per cent.

Take the case when you buy a $750 automobile by paying one-third down and agreeing to pay off the balance in twelve months. The finance company tells you that the finance charges will be $29.92 on the $500 you owe it. You might think you were paying less than 6 per cent, since 6 per cent of $500 is $30.00. Actually, you would be paying at the annual simple interest rate of 11.6 per cent on the average unpaid balance, assuming that the financing charge is equally distributed over the twelve months.

Figure it out for yourself and know what you are getting into!

Can you figure out how much you would have saved if you had waited until you could pay cash for your car instead of buying it on credit? Suppose that instead of making your payments to the finance company you had deposited the same amount of money in a savings bank that paid 2 per cent interest. At the end of the year the accumulated interest would be $7.36. Therefore your $750 car would cost you, a net of $742.64 instead of $779.92, as it did with the finance charges added.

Would the saving of $37.28 be worth waiting a year for?

From EM 36: Does It Pay to Borrow? (1945)