Let’s imagine that Brian takes out a loan of $8,000 to buy a car.  He agrees to a 9% annual interest rate and to pay off his debt by making monthly payments for a 12-month term.

 

While 9% is the annual interest rate, the lender informs Brian that the interest will accrue (build up) monthly.  Therefore, we will use his monthly interest rate, which is 9% ÷ 12 = 0.75%.

 

Each month then, Brian must pay an additional charge of 0.75% of his remaining balance.

 

After the first month, Brian will owe $8,000 x 0.75% = $60 in interest.

 

Let’s say Brian makes a payment of $700.  The first $60 will go toward the accrued interest and the remaining $640 will go toward the principal—the amount he still owes from what he initially borrowed.

 

After the second month, Brian’s new principal balance is $8,000 – $640 = $7,360.  Thus, his interest charge will be $7,360 x 0.75% = $55.20.

 

In a “Constant Payment” loan, Brian will again make a payment of $700.  This time around, however, a little bit more of that payment will go towards the principal, because he owed less in interest.  

 

Each month, Brian’s interest payment will decrease, meaning more of his $700 will go towards paying back the loan.  As it turns out, with 12 payments of $700, he will entirely pay off his debt.  He will have paid back $8,000, plus around $400 in interest.

 

We chose this example because it happens to have pretty round numbers.  However, in most loan arrangements like this, while the loan amount and interest rate may be easy round numbers, the monthly payment will be something complicated and harder to calculate.  If you are interested in the math, check out Khan Academy’s class on loan payment calculation.

Let’s imagine Caroline takes out a loan of $50,000 for her bicycle shop.  She agrees to a 6% annual interest rate.  While the loan needs to be paid off entirely within 3 years, she is only required to pay the interest each month.

 

The interest rate is 6% annual, but the interest accrues on a monthly basis.  Therefore, we will use her monthly interest rate, which is 6% ÷ 12 = 0.5%.

 

After the first month, Caroline will owe $50,000 x 0.5% = $250 in interest.

Each month for 3 years, Caroline will pay $250.  This adds up to 36 payments x $250 = $9,000.  At the end of 3 years, Caroline will still have to pay back the loan itself ($50,000), and will owe what’s called a balloon payment.  In total then, Caroline will have paid $59,000.

 

Caroline may decide she wants to start paying down her loan earlier in the process.  Let’s imagine that halfway through her loan (18 months), Caroline makes a payment of $20,000 towards the principal (the amount she still owes).  

 

For the remainder of her loan, her monthly interest payments will now be based off her new principal balance: $30,000 x 0.5% = $150.  At the end of her loan, she will have paid 18 payments @ $250 + 18 payments @ $150 = $4,500 + $2,700 = $7,200.  In addition to the principal payment of $20,000, she’ll make a balloon payment of $30,000 at the end.  In total, she will have paid $57,200.

 

The benefits of paying down her principal early are two-fold: 1. she pays less in interest overall, and 2. her balloon payment at the end will be smaller.  Assuming there is no pre-payment penalty, it’s a smart move!

Nick would like a loan for $50,000 for his food truck business.  His lender wants to charge 10% annual interest and for it to be fully paid back via monthly installments over a term of 5 years.  If this loan were a fully-amortized, constant payment loan, the monthly payment would come out to almost $900/month.  (Use our Loan Calculator above to see for yourself.)

 

Nick knows he can’t afford this payment and asks for a 10-year loan, since the monthly payment will only be $482.  His lender understands his situation, but is also resistant to extending a loan out 10 years—the food truck business can be volatile, and his truck, business, etc. may not be worth much 10 years from now.  It’s a risk for them.

 

Fortunately, they are able to reach a compromise.

 

The loan will be amortized over 10 years, which means Nick will keep the lower payment of $482/month.  At this rate, it will take 10 years for the loan to fully pay off (or amortize).  However, the term on the loan itself is still 5 years.  This means that at the 5-year mark, the entirety of the remaining loan is due.  He will have to make a large balloon payment.  

 

This is what’s sometimes referred to as a “partially-amortized loan.”  

 

As long Nick understands what’s happening, it can be a good arrangement.  During the first five years, he has sufficient cash flow to build his business up and increase profitability, in hopes of making his balloon payment at the end.  If he can’t afford to pay it off entirely at the 5-year mark, he may be able to get another loan to pay off the first one (referred to as “refinancing”) and then continue making payments till he’s out of debt.

 

The danger to this type of loan is when the borrower thinks they’ll be paid off at the end and doesn’t realize they have a balloon payment.  In addition, the size of the balloon may be larger than expected.  In this example, you might expect Nick’s balloon to be $25,000 since he’s halfway through the amortization period, but it’s actually about $31,100. (It’s higher because during the early period paying back a loan, most of the payments are going towards interest, rather than principal.)