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Chapter 8: Problem 19

Describe what happens to the portions of payments going to principal and interest over the life of an installment loan.

Short Answer

Expert verified
The portion of an installment loan payment going to interest is highest at the start of the loan, when the principal is highest, and decreases over the life of the loan as the principal decreases. Conversely, the portion going to the principal increases over the life of the loan.

Step by step solution

01

Understanding the Terms

Before breaking this down, it's important to understand what these terms mean. 'Principal' is the original sum of money borrowed in a loan, and 'interest' is the cost of borrowing that money. In an installment loan, you repay the loan amount (principal) along with interest over a fixed period in regular, usually monthly, installments.
02

Payment Allocation in the Early Stage of the Loan

At the beginning of a loan repayment, the principal is at its highest. For every installment payment made, a portion goes towards the interest and a portion goes towards the principal. At this stage, since the principal is high, a majority of the payment goes towards paying off the interest.
03

Payment Changes over the course of the loan

As the principal slowly gets paid off, the interest accrued on this principal decreases. So, over the course of the loan, the portion of the installment payment that goes towards interest becomes less and less.
04

Payment Allocation in the Final Stages of the Loan

Toward the final stages of the loan, as the principal has been largely paid off, the majority of each installment payment goes towards paying down the remaining principal. By the end of the loan term, virtually all of the final few payments are going towards the remaining principal, with very little going towards interest.

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