Legal Definitions - actuarial method

The actuarial method is a standard way of calculating interest on a loan, ensuring fairness by basing interest charges on the actual outstanding principal balance. Under this method, each payment made by the borrower is first used to cover the interest that has accrued since the last payment. Any remaining portion of that payment is then applied to reduce the loan's principal balance.

This approach means that as the principal balance decreases over time, the amount of interest charged in subsequent periods also decreases, allowing more of each payment to go towards reducing the principal.

Here are some examples illustrating the actuarial method:

• Home Mortgage: Imagine a family takes out a 30-year mortgage to buy a house. Each month, they make a fixed payment. Using the actuarial method, the bank first calculates the interest that has accumulated on the remaining loan balance since the last payment. The rest of the family's payment then directly reduces the principal amount they owe on the house. Over the years, as the principal balance shrinks, a larger portion of their monthly payment goes towards reducing the principal, and a smaller portion covers interest.

• Car Loan: When an individual finances a new car over five years, their monthly loan payments are typically structured using the actuarial method. For each payment, the lender first determines the interest due on the current outstanding balance of the car loan. The remaining part of the payment then reduces the principal amount owed. This systematic application ensures that interest is always calculated on the *actual* remaining debt, leading to a steady reduction of the principal over the loan term.

• Small Business Loan: A small business owner secures a loan to purchase new equipment, agreeing to monthly repayments. Each month, when the business makes a payment, the bank applies the actuarial method. This means the bank first calculates the interest that has accrued on the outstanding loan balance since the previous payment. Whatever is left from the payment then directly reduces the principal amount of the loan. This process continues until the loan is fully repaid, ensuring that interest is always charged on the diminishing principal.