Annuity payment

What it means

An annuity payment is an instalment of the same size for the whole term: part covers interest, the rest repays principal. Interest dominates at the start and principal at the end, while the sum never changes.

An equal instalment does not mean an equal price for the money. The real cost shows in the annual percentage rate of charge, which includes fees, and a floating rate resets the annuity.

The alternative is repaying equal amounts of principal: every instalment cuts the debt by the same sum and interest is charged on the falling balance. Early instalments are then higher and shrink over time, but at the same rate and term less interest is paid in total. An annuity spreads the burden evenly; equal principal pays the loan down faster.

How it works in practice

In the books the instalment is split: interest is a finance cost of the period, principal reduces the liability to the bank. The evidence is the amortisation schedule the bank issues on drawdown and redoes when the rate moves.

When the interest fixation ends the bank resets the instalment to the new rate while the maturity date stands; only refinancing rebuilds the repayment schedule. An extra payment cuts the principal, but whether the instalment or the term then shrinks must be agreed.

With leasing the payments behave in a similar way, but the accounting depends on the contract type. Under a finance lease the instalment splits into principal, which reduces the liability, and interest, which is a cost; under an operating lease the whole rental is a cost of the period. So for each contract we ask for the schedule and set up the split from the first instalment.

What to watch out for

An equal instalment tempts a borrower to compare offers by its size alone. A longer term shrinks the instalment but raises the interest paid over the life of the loan, and since only a sliver of each early payment touches the principal, after a few years the debt has fallen far less than the money that left the account.

The second mistake is booking the whole instalment as a cost. Profit is then understated by the principal, the tax base is wrong and the liability to the bank on the balance sheet never shrinks although the company keeps paying. The gap only surfaces against the balance the bank confirms at year end, and the whole period has to be corrected.