Interest application lets you choose whether interest should come due based on how much interest accrues between payment periods or payment, or in some cases credit, transactions between transactions. These options will not affect the original payment schedule, but they do determine how much interest will come due when a payment applies and the date payments apply to the loan.
When you log a payment, you will see different options for extra towards, depending on your interest application. See the Extra Towards Mapping article to understand how changing this setting can change your payment application.
In the between transactions scenario, payments will apply to interest that accrues on the loan daily. Interest will not show up as part of the amount past due on the loan unless the scheduled payment that should have covered that interest has passed without being paid.
Here is an example of how a payment will apply in a between transactions scenario:
As you can see, the first payment on this loan came due on 10/01/2015. The payment wasn’t actually made until 10/10/2015. In the scheduled payment, the interest is $205.48. In the actual payment $267.12 applied towards interest. The reason for the additional interest accrual is the extra days that passed between the due date and the date the payment was actually made.
So, how is the interest calculated in this situation? This is a $10,000 loan with a 25% interest rate and a term of 24 months. Due interest is calculated as:
daily interest rate x outstanding principal balance x number of days since the last payment
To calculate the daily interest rate, divide the yearly interest rate by the number of days in a year. This loan is using the actual number of days in a year. Since the payment frequency is monthly, the days in a payment period is 30.
So, we’ll do the math:
25% (yearly interest rate) / 365 (days in year) = 0.0685% daily interest rate
Now we can calculate the interest that should be paid by the payment on 10/10.
0.000685 (daily interest rate as a percentage) x 10,000 (outstanding principal balance) x 39 (days since the contract date) = $267.12 interest paid by the first payment.
In a Between Periods scenario, interest comes due by period. When a payment is made, it covers the interest for the current period, or the previous period, if the payment is made late.
Payments that are made late impact the average daily balance for the next period, so interest in the subsequent payment period will be higher. Let’s first calculate the interest for the payment that was made on 10/10. We can do this by multiplying the daily interest rate by the average daily balance and the number of days in the period. First we will compute the daily interest rate.
25% (annual interest rate) / 365 (number of days in the year) = 0.06849315%
Now we will compute the first period interest.
0.0006849315 (interest rate converted to a decimal) x $10,000 (average daily balance for the first payment period) x 30 (number of days in the first payment period) = $205.48
Now we will compute the interest portion as shown in Forecasted Payment: 2. The daily interest rate will be the same (0.06849315%) so we will start by computing the new average daily balance. This is done by taking a weighted average of loan balances for the payment period.
Let’s do the math:
$10,000 (principal balance at the beginning of the period) x 9 (days in the period before the payment applied) = 90,000
$9,671.76 (principal balance at the end of the period) x 22 (days in the period after the payment applied) = 212778.72
90,000 (daily total for first 9 days) + 212778.72 (daily total for last 22 days of the period) = 302778.72 total of daily balances for the period
302778.72 (total of daily balances for the period) / 31 (days in the period) = $9767.06 (average daily balance for the period)
Now we can compute the interest for the period.
0.0006849315 (interest rate converted to a decimal) x$9767.06 (average daily balance for the first payment period) x 31 (number of days in the first payment period) = $207.38
You can give the borrower the benefit of an early payment by choosing Yes from the Early Payment drop-down when you log the payment. Choosing Yes for this option will do an average daily balance adjustment in the period when the payment is made causing less interest to accrue.