Why is it that the effective rate is based on compounding and it is also paid only on the remaining loan balance in compounding interest we pay interest on interest? Can someone explain in to me? what do we mean that the effective rate is based on compounding.
In this example: The specification says that "The monthly and total repayment should use monthly compounding interest".
Program input: Requested Amount, Rate, Loan length in months
Program output: monthly repayment, total repayment amount
Requested amount: £1000
Monthly repayment: £30.78
Total repayment: £1108.10
If I used the formula for calculating the compound interest rate is
A = P (1 + r/n) ^ nt
A = the future value of the investment/loan, including interest
P = the principal investment amount (the initial deposit or loan amount)
r = the annual interest rate (decimal)
n = the number of times that interest is compounded per year
t = the number of years the money is invested or borrowed for
Using this on our example we get A = 1000*(1+0.07/12)^(36) = 1232.92, which is not 1108.10 as they say in their example.
So my question is since effective rate is based on compounding why didn't we use the formula mentioned above instead we used the EMI for reducing balance with function PMT which equals 30.79.
My question who is it correct that effective is based on compounding effect in which we pay more interest and yet the repayment is based on reducing balance where we pay less interest