A mortgage note payable with a fixed interest rate requires the borrower to make installment payments over the term of the loan. Each installment payment includes interest on the unpaid balance of the loan and a payment on the principal. With each installment payment, indicate the effect on the portion allocated to interest expense and the portion allocated to principal.

Portion Allocated to Interest Expense Portion Allocated to Payment of Principal

a. Decreases, Increases

b. Increases, Increases

c. Increases, Decreases

d. Decreases, Decreases

Answer: a. Decreases, Increases

Explanation:

With each installment paid, the interest expense goes down while the principal repayment goes up. This is because the amount of Principal reduces with every payment therefore the interest is charged on a lesser figure.

For example, assume $10,000 is to be paid per month on $100,000 mortgage with a 10% rate.

The first time the 10% is charged on $100,000 it will give $10,000 and since the payment is $10,000, all of it will be considered interest.

The second time the 10% is charged it will be charged on $90,000 (100,000 - first payment of $10,000) instead which will. mean interest payment is now only $9,000 (10% of $90,000). The difference of $1,000 ($10,000 payable every month and interest of $9,000) will be Principal repayment.

The third time around then, the amount left is $80,000. Interest payment will be $8,000 and Principal repayment becomes $2,000.

And so on and so forth.