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What is U.S. Rule?

Problem When there is a long delay between the loan date and the first payment or when payments are skipped or late, it sometimes happens that a loan payment doesn't cover all the interest due. The normal amortization method would add this unpaid interest to the balance. This standard actuarial method makes sense since in effect, the unpaid interest constitutes an additional debt. Some U.S. states have passed legislation that forbids to charge interest on interest (also known as U.S. Rule). In these situations it may not be legal to use the actuarial method. FinFlow checks whether negative amortization occurs for typical loan situations that could require U.S. rule to be applied: •

simple interest is selected as the compounding frequency

•

there is only one outflow followed by a series of inflows

•

some of the payments don't cover the interest on the outstanding balance

In such situations a "Negative amortization" label and a US Rule checkbox are displayed. If checked, FinFlow keeps track of the unpaid interest internally and does not take it into account when calculating the next balance. The resulting balance is displayed in italic to indicate that there is unpaid interest. Example A sum of $1,000 is loaned on January 1, 2000. It is repaid in 30 monthly payments starting July 1st, 2000. If the interest rate is 48 % simple interest, what will be the monthly payment if interest on interest is allowed? Set up the following cash flow or open the "US Rule - Example" file in the Help examples folder. Comment Loan Payment

Type outflow unknown

Occurs once monthly

Date Amount 1-1-2000 1,000 7-1-2000 1

Occurrences Change 30

Step

no change

Enter 48 into the rate field and select simple interest as the compounding method. Make sure that Auto update is checked. The program calculates a payment of $68.95. When you switch to the Amortization pane, you'll notice that the first payment ($68.95) doesn't cover the interest due ($240). What if? In the above example, what would be the monthly payment if U.S. Rule were used? Simply check the US Rule checkbox: the payment now becomes $67.70 or $1.25 less. Multiplied by 30 (the number of payments), the difference becomes $37.5. Simple interest versus compound interest

Using this example you can also see what the difference is between simple and compound interest. Select "monthly" as the compounding frequency: due to compounding over the first six months, the interest due on the first payment date is now $265.32 instead of $240, and the payment becomes $70.36 or $2.66 more. Multiplied by 30 (the number of payments), the total finance charge is $79.8 higher. Note: this example could give the impression that compound interest is always higher than simple interest, but that isn't the case. Selecting "semiannually" as the compounding frequency will lead to $240 being due on the first payment date, and - even with negative amortization - will result in a lower monthly payment $66.28. This is due to the fact that when payments occur more often than compounding, compound interest is less than with simple interest. To see this effect, switch to "annually" as the compounding frequency. Half way the compounding period, the interest generated is only $216.55. As opposed to simple interest which follows a straight line, compound interest is an exponential function which can be viewed as a curve. Suppose that k is the number of interest periods and that c is the compounding frequency: If k is greater than c, the compound interest formula will produce higher values, but when k is less than c, it will produce lower values. Only when k and c are the same, simple interest will yield identical results as with compound interest.