How to compute a Home Equity Loan
Rather than taking out a Home Equity loan, I've decided to lend the
money to my Wife's business. I'm having trouble, however, figuring
out how much she needs to repay me.
The terms of the loan are as follows:
Loan amount: $8000
Interest Rate: 4% apr
term: 5 years
The simple interest calculator I used computed the monthly payment to
be $160.
using I=PxRxT where P= principal, R= interest, and t = time in years.
My problem is that the loan rate calculators on Bankrate and such
compute the monthly payment to be 147.33. I don't know what formula
they use.
Which is correct? I don't want to cheat either myself, or my wife's
business!
I use a spreadsheet that I developed years ago to figure out montly
payments for mortgages. I plugged in your numbers, $8K principal,
4%, 5 years, and came up with $147.33.
When I do your formula, I do indeed get $160. It all depends on
how you compute interest. In the case of simple interest, you are
assuming that she pays interest on the full $8000 for 5 years.
When using compound interest, you are assuming that she is only
paying on the remaining balance each month, and that balance goes
down with each payment.
For example, in the 5th year of the loan, your formula charges
a full $320 for interest (8K x 4% x 1 year), while with compound
interest, the remaining balance is $1730 at the start of the 5th
year, with total interest paid during the 5th year of $37.72.
If you want to go with simple interest, a more fair way would be
to compute it each year.
Year 1, balance $8000, 4%, interest for year is $320, payment = $160
Year 1, balance $6400, 4%, interest for year is $256, payment = $155
Year 1, balance $4800, 4%, interest for year is $192, payment = $149
Year 1, balance $3200, 4%, interest for year is $128, payment = $144
Year 1, balance $1600, 4%, interest for year is $64, payment = $139
Doing it monthly is the same as compound interest computed monthly.
Also, computing the loan on a monthly basis allows you to account
for uneven payment flow. For example, if a month is missed, you
can do negative amortization. If extra is paid, the loan is
automatically paid down.