Question

True or False: Computing interest using the sum-of-the-digits method allocates more interest at the beginning of a loan than at the end of the loan.

Answer 1

Answer:

True

Explanation:

To illustrate how the sum-of-the-digits method allocates interest we can use a lease example:

You are the lessor and you will lease a machine during 4 years. The lease requires 4 equal payments of $100,000 at the beginning of the year. After the lease, the asset's salvage value = $0.

The asset's current value = $300,000, so total interests received = $100,000

Using the sum-of-the-digits method, you will allocate interest as follows:

• year 1 = 3/6 x $100,000 = $50,000
• year 2 = 2/6 x $100,000 = $33,333
• year 3 = 1/6 x $100,000 = $17,000

The largest portion of interests is allocated during the beginning of the loan.