The amount of the installment and the cost of the loan are determined not only by the amount borrowed, interest rate and repayment period. The cost of our commitment is also affected by the method of loan repayment – equal or decreasing installments. We advise you on what solution to choose in order to repay the loan most advantageously.
When choosing a loan, we often do not think about how to pay back the loan – will we pay it back in equal installments or in decreasing installments? Often the only criterion is the lowest installment of the loan, we do not assess its costs over the entire loan period. However, in the case of equal installments, despite the fact that during the initial repayment period we pay smaller installments, we will pay more interest throughout the entire repayment period.
What installment amount?
In the case of loan repayment in the system of decreasing installments, we pay back an equal amount of capital in each installment. For example, if we borrowed 250,000 dollars for 25 years (300 months), then every month, regardless of the interest rate, we will repay 833 dollars of capital in installments. This is due to dividing the borrowed amount by the number of installments. In addition to the capital installment, we will also pay interest on the current debt every month. In the first installment of the above example, at an interest rate of e.g. 3.6%, interest will be charged $ 750 during the month. However, in the next month, interest will already be calculated on the amount less capital paid in the previous installment, i.e. on the amount of $ 249167. Thus, the second installment is still 833 dollars of capital and 747 dollars of interest. In the following months, the amount of capital will not decrease ($ 833), but interest will systematically decrease and, as a consequence, subsequent principal and interest installments as per the name will be decreasing.
In the system of equal installments, interest is also calculated on the current debt, however, in order for the principal and interest installment to be equal throughout the repayment period, it is calculated using a complicated formula. For a 25-year loan in the amount of $ 250 thousand and an interest rate of 3.6%, the installment will be equal to $ 1265. Along with decreasing debt, interest increases in subsequent installments, and the share of capital repaid increases. For this reason, in the case of equal installments, there is often the illusion that at the beginning we pay only interest, and we hardly pay back capital. This unfavorable large proportion of interest is the higher the higher the interest rate on the loan.
When will the installments be equal?
Equal installments throughout the repayment period do not change, assuming, of course, that the interest rate does not change. In the case of decreasing installments, their amount decreases in subsequent periods, however, during the initial repayment years their amount is higher than with a similar loan, but in equal installments. The moment when the decreasing installment falls below the equal installment depends on the interest rate and the repayment period. In the example above, at an interest rate of 3.6% and a repayment period of 25 years, the decreasing installment will be lower than the installment after 128 months, or 42 percent of the repayment period. However, if the loan were taken for 10 years (120 months), the decreasing installment will be lower than the equal after 57 months, i.e. 47 percent of the repayment period. However, if we get into debt for 35 years (420 months), then with decreasing installments we will start paying less after 168 months, which is 40 percent of the repayment period.
The data will look different if the loan interest rate is e.g. 6.00%. Then, for a loan taken for 25 years, the decreasing installment will fall below the equal installment after 115 months (38 percent of the repayment period). For a 10-year commitment, the installment will be lower than for an installment equal after 55 months (45 percent of the repayment period), and for a 35-year loan after 143 months (34 percent of the repayment period). Thus, the higher the interest rate or longer repayment period, the faster the decreasing installment will fall below the equal installment.
Installment type and amount of interest
The installment amount is only one element of the loan. When choosing a repayment method, you should also be aware of the impact this will have on the total amount of interest paid over the entire repayment period. The table below presents the total interest cost depending on the interest rate and repayment period for the loan in the amount of $ 250 thousand.