Farming requires capital. Most farmers require borrowed capital. Do you know how to calculate the payment on a loan? Do you know the trick most banks use to take more of your money? Hint: How many days are in a year? If you answered 365 you are not a banker.
I came home from college one weekend and found my parents at the kitchen table scratching their heads. They couldn’t figure out how the bank came up with the yearly payment due.
I had taken “Math of Finance” in college. I told them, “I got this,” implying a young mind was needed. They were gracious enough to let me try.
Let’s say the loan was $10,000 dollars at 8% for one year. Common sense would tell you $800, right? Why was the payment due $811.11?
1. Take the interest rate, 8%. Move the decimal over two spots to the left, .08.
2. Divide .08 by the number of days in a year, 365 days, equals .000219178, the daily rate.
3. Multiply the daily rate by the principal, $10,000 dollars equals $2.19178, the daily charge.
4. Multiply the daily charge by the number of days in the loan. In this case, 365 days times $2.19178 equals $800.
This is where my parents smile and tell me this is what they came up with too. Let’s figure it again. $800. Ok, maybe there was a leap year, or the loan term was for a few more days than 365. Look at the loan. Look at the calendar. Count the days. Nope.
Ok, we’re not too proud. Let’s go see our loan officer and ask him to figure it out for us.
He got out our loan application and showed us where there were two boxes. One was to calculate the loan based on a 365 day year. One was to calculate the loan based on a 360 day year. Our loan had the 360 day year checked.
So now we figure again.
- Take the interest rate, 8%. Move the decimal over two spots to the left, .08.
- Divide .08 by the new number of days in a bank year, 360 days, equals .000222222, the daily rate.
- Multiply the daily rate by the principal, $10,000 dollars, equals $2.22222, the daily charge.
- Multiply the daily charge by the number of days in the loan. It’s still 365 days; because this is how many days we had the loan. So 365 days times $2.22222 equals $811.11.
Ok, we see. But why does the bank use a 360 day year? What is that, a Mayan calendar or something? The loan officer hemmed and hawed and couldn’t answer us. Finally, he took us to the bank president who told us it was to increase the bank’s yield.
Take out your loan and see if it’s calculated with a 360 day year. This is what is called, “increasing the bank’s yield.” What would you call it?