A simple rate loan of money is paid back in equal installments, as interest accrues on the outstanding balance. The money paid each month goes partly to paying the monthy interest on the loan, and partly to paying down the outstanding balance of the loan. The payment is adjusted so that after a certain number of payments, the loan term, the balance is zero. The outstanding balance is also called the Principal. The number of payment installments is called the Term.
Note: An Auto loan, and many other consumer loans, use the Rule of 78 to calculate the balance in cases where you wish to pay off the loan early. In that case, the outstanding balance is more than is calculated by simple interest. That's how things are: banks are allowed to penalize you slightly for paying off these loans early. It makes no sense to payoff these sorts of loans after about halfway through.The formula for these loans looks complicated, but it reveals an interesting fact, which has much meaning. Making a simple interest loan and paying it off in installments is mathematically equivalent to making two seperate deals:
- make a simple interest loan which you pay off with a lump
sum payment at the end of the loan, letting the interest on the initial principal accumulate,
- open a savings account which pays the same interest as the the loan, and make monthly installments to the account. At the end of the loan, the amount in the savings account equals the amount due on the loan, so you pay off the loan with the account balance, closing both.
The amount due on the loan, with accrued interest, is: that is, the principal compound with its interest for Term times. The amount saved in the bank is: that is, add up all the payments, applying individually to each, how the interest compounds as the payment sits in the bank.
The hard part is making sense of the large sum of payments compounded each by a different factor. Mathematicians know the formal power series: This is an infinite sum. This series is truncated by subtracting itself from itself after it has been shifted up by the desired amount: So the payment sum is also written: where