Terry Martinez is considering taking out a loan to purchase a desk. The furniture store manager rarely finances purchases, but will for Terry “as a special favor.” The rate will be 10% per year, and because the desk costs $600, the interest will come to $60 for a 1-year loan. Thus, the total price is $660, and Terry can pay it off in 12 installments of $55 each.
a. Use the interest rate of 10% per year to calculate the net present value of the loan. (Remember to convert to a monthly interest rate.)Based on this interest rate, should Terry accept the terms of the loan?
b. Look at this problem from the store manager’s perspective. Using the interest rate of 10%, what is the net present value of the loan to the manager?
c. What is the net present value of the loan to the manager if an interest rate of 18% is used? What does this imply for the real rate of interest that Terry is being charged for the loan?
This kind of financing arrangement was widely practiced at one time, and you can see why from your answers to Question c. By law, lenders in the United States now must clearly state the actual annual percentage rate in the loan contract.