Installment notes may be designed with virtually any schedule of payments, but they most frequently conform to one of two basic payment schedules. Level-principal notes schedule equal periodic payments of principal on the note together with accrued interest. For example, if the principal value of the note is $1,000 and it is to be paid off over 5years, the debtor would pay $200 of principal each year together with the accrued interest. If the interest rate were 10 percent, for instance, the first payment would be $300, $200 of principal and $100 of interest. The second payment would be only $280, $200 of principal and$80 of interest on the remaining principal balance. Although the principal amount is fixed or level each year, the total payment declines each year because of the decreasing interest component of the payment.
Level payment self-amortizing notes are the second and most frequently used type of installment note. This type of note is similar to the standard home mortgage with level annual payments. With this type of note, the principal portion of each payment starts low but increases with each payment. Conversely, the interest component starts high but declines with each payment as a greater portion of the principal on the note is paid off.
In either case, the term of the installment note may be less than the amortization or principal recovery period of the note. If the amortization or principal-recovery period of the note is greater than the term of the note, the last payment in the term of the note, called a balloon payment, is larger than the rest of the payments. It is equal to the remaining principal balance of the note plus the normal payment.
For example, assume the client discussed above wants the term of the note to remain at 3 years, but wants the payment schedule to be based on a 5-year amortization period. In this case, the first two payments would be less than the $39,634 determined above, but the final payment would be higher. Specifically, the first two annual payments would be equal to $25,498 and the third-year payment would be equal to $71,985.
Deferring a larger portion of the repayment on the note to the later years increases the risk premium. In this case, the principal risk premium is $6,248, or $1,085 more than the $5,163 risk premium associated with three equal annual payments of $39,634. Similarly, the interest rate risk premium also increases. In this case, it is 2.8065 percent as compared with the 2.7826 percent associated with the three equal annual payments.