The Impact of the Extra-Costs on the Global Cost of Credit

Abstract

In this note, we analyze the impact of the extra-costs payment schedule on the Effective Annual interest Rate (EAR), one of the most popular global cost measures of consumer credit loan payments. First, we prove that the EAR can be expressed by the financing credit interest rate with an extra-costs interest rate addendum, and we investigate the drivers of this latter. We show that the extra-costs interest rate decreases if extra-costs payments are postponed. Consequently, the EAR is minimum if extra-costs are charged in a lump sum at the expiry date of the contract and maximum if they are charged in a lump sum at the contract beginning time. To explain how the schedule of payments impacts on the EAR, we develop a sensitivity analysis through illustrative applications. We also highlight that EAR depends on the timing of extra-costs payments. In particular, we show that EAR decreases with the increase in the Modified Duration of the cash flow of extra-costs. The results of the paper are useful to provide decision-makers a better awareness about how to spread the extra-costs payments during the contract lifetime and, therefore, to define the structure of consumer credit loan payments to supervise the global cost of the financing.