Interest is the amount charged by an individual or a lending institution for borrowing funds. The terms of any loan should be negotiated and established in writing before a loan is accepted. Simple interest is calculated by the interest rate or percentage multiplied by the repayment period.

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Example:

A bookstore borrows  $15,000 from a bank to get the business started. The total that the bank will receive is the principal of $15,000 plus the interest charged on the loan. If the loan has an interest rate of 8 percent per annum and is scheduled to be paid back over a five-year period, the interest would be figured as follows:

= [Principal x Interest] x Term of the Loan

= [15,000 × 0.08] × 5 years = $6,000

 

The interest charged on the loan is $1,200 per year, for a total of $6,000 over the life of the loan. So, the bookstore will pay the bank $21,000 for the use of the initial $15,000.

If you divide that by the number of installment payments to be made (21,000/60 months), the bookstore will be making payments of $350 per month on the loan. Each payment will be recorded in the accounting system. However, to do that accurately, you must first figure out how much of the payment should be posted to the principal amount in the “Liabilities” section of the General Ledger, and how much should be posted to the “Interest Expense” account.

To do that, you divide each part of the loan separately by the number of payments. Your worksheet will look like this:

  • Principal: 15,000/60 = $250 per month
  • Interest: 6,000/60 = $100 per month

 

 

How to Record the Loan Principal and Its Interest

Each month when the payment is made to the bank, the entry will be posted as follows:

[Debit]. Loan Payable – Bank = $250.00
[Credit]. Interest Expense = $100.00
[Credit]. Checking Account = $350.00
To record loan payment:

  • “Checking Account” is credited as cash is going out of the account. Loan Payable-Bank, which has a credit balance, is debited to reduce the amount of the liability.
  • Interest Expense is debited to record the amount of interest that has been included in the payment.

 

Look at the liability account in the General Ledger as the loan payments are made over a period of three months to understand how each payment posted reduces the liability amount.

 

Loan Payable–Bank

Beginning Balance          0.00
Opening Entry       15,000.00
Loan Payment           (250.00)
Loan Payment           (250.00)
Loan Payment           (250.00)
Ending Balance      14,250.00

 

Note:

The principal amount of the loan is not a deductible expense to the bookstore, but it is important to update the account so that the Balance Sheet will show that the liability is being reduced each month.

There may be other types of business indebtedness recorded as Liabilities in the Balance Sheet accounts.

Most installment loans come with a payment coupon book. As soon as you figure the interest and principal amounts of the payment, note the breakdown in the payment book. That way you will have the information on hand and can note it on the check stub so that it can be posted accurately.

 

If the business owns a building, it may also have a mortgage loan. A mortgage is a long-term loan used to finance a particular piece of real estate. Some mortgages have fixed interest rates that stay in effect for the entire repayment period. Other mortgages have adjustable interest rates. These are commonly referred to as “Adjustable Rate Mortgages (ARMs)“. This means that the interest rate can be adjusted either up or down during the life of the loan. Usually the adjustment is based on some type of standard.

Interest on both types of mortgages is compounded—that is, the interest charged for one period is added to the principal before the interest for the next period is calculated. The result is that the allocation of principal and interest changes with every payment.

Some lenders send out monthly statements that show the breakdown of principal and interest for the prior month, so your entry could be based on that statement. If the mortgage lender does not send out a monthly statement, ask for an amortization chart that will allow you to estimate the amount of the interest month by month.  At the end of the year, the lender is required to send a statement that itemizes the principal, interest, taxes, and insurance paid during the year. When that is received, the mortgage interest for the year can be adjusted to the actual amount.