Calculating Principal Reduction in an Installment Note

How much of the second payment would reduce principal?

Which of the following options correctly indicates the amount that the second payment would reduce principal?
$300
$805
$495
$505
$535

Answer:

The second payment would reduce the principal by $505.

To calculate the principal reduction in the second payment of an installment note, we need to consider both the interest and principal components of the payment. In this scenario, a company borrowed $5,000 using an 8-year installment note with an interest rate of 6%. The annual payment of $805 includes both interest and principal, with payments due on each December 31.

To determine the principal reduction in the second payment, we first calculate the interest portion. The interest is calculated by multiplying the outstanding principal balance by the interest rate. In this case, the interest portion of the second payment is $300. By subtracting the interest from the total payment of $805, we find that the principal reduction for the second payment is $505.

Understanding how the portions of an installment payment contribute to reducing the principal amount borrowed is crucial for effective financial management. By tracking these payments over time, companies can ensure they are making progress towards repaying their loans and reducing their overall debt obligation.