The amount of the installment and the cost of the housing loan is determined not only by the amount borrowed, interest rate and the repayment period. The cost of our liability is also affected by the method of repayment in equal or decreasing installments.
When choosing a home loan, we do not think about how to pay it back – 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, although we pay smaller installments during the initial period, 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.
Example: if we borrowed 250,000 dollars for 25 years (300 months), then every month we will repay 833 dollars of capital in installments regardless of the interest rate. 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 example above, at an interest rate of, for example, 3.6 percent, USD 750 will be charged in a month, ”calculates Michał Krajkowski, chief analyst at Good Finance.
And he explains: – 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 USD 24,167. 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 (USD 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 calculated on the current debt, but in order for the principal and interest installment to be equal throughout the repayment period, it is calculated using a complicated formula.
Example: For a 25-year loan of USD 250,000 and an interest rate of 3.6 percent, the installment will be USD 1265. Along with decreasing debt, interest increases in subsequent installments and the share of capital repaid increases.
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 – explains the chief analyst of Good Finance.
Example: At an interest rate of 3.6 percent and a 25-year repayment period of USD 250 thousand – the decreasing installment will be lower than the installment equal after 128 months of repayment, i.e. 42 percent of the repayment period.
If the loan were contracted for 10 years, i.e. 120 months, the decreasing installment will be lower than the equal after 57 months, i.e. 47 percent of the repayment period.
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.
Example: The data will look different if the loan interest rate for USD 250,000 is for example 6.00 percent. 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.