A business obtains a principal and interest loan of 500 at an annual interest rate of 6% to be repaid in 3 annual loan repayment installments of 187.05 at the end of each year.
For this type of loan the cash payments (187.05) are the same each period throughout the term of the loan, and include an amount paid off the principal loan balance (originally 500), and an amount for the interest on the loan for the accounting period.
For the purpose of making the loan repayment journal entries it is necessary to split each of the cash payments into the principal and interest elements as they are posted to different accounts.
Loan Repayment Schedule
The first step is to produce a loan repayment schedule as shown below.
| Beginning | Interest | Payment | Ending |
|---|---|---|---|
| 500.00 | 30.00 | -187.05 | 342.95 |
| 342.95 | 20.58 | -187.05 | 176.47 |
| 176.47 | 10.59 | -187.05 | 0 |
As can be seen each line of the table is based on the formula as follows:
To illustrate suppose we use year one as an example, the beginning loan principal balance is 500, the interest added to the account is calculated as 500 x 6% = 30, and the repayment deducted is 187.05.
As the interest is 30, then the principal repayment is 157.05 (187.05-30.00), and the ending balance of 342.95 represents the outstanding principal balance on the loan.
Loan Repayment Bookkeeping Journals
The following bookkeeping journals are needed to record the interest payment and the principal repayment each period.
Year 1 Loan Repayment
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 30.00 | |
| Loan account | 157.05 | |
| Cash | 187.05 | |
| Total | 187.05 | 187.05 |
As can be seen the principal repayment is 157.05 which is the cash payment of 187.05 less the interest expense of 30.00.
Year 2 Loan Payment
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 20.58 | |
| Loan account | 166.47 | |
| Cash | 187.05 | |
| Total | 187.05 | 187.05 |
As can be seen the principal repayment is 166.47 which is the cash payment of 187.05 less the interest expense of 20.58
Year 3 Loan Payment
| Account | Debit | Credit |
|---|---|---|
| Interest Expense | 10.59 | |
| Loan account | 176.46 | |
| Cash | 187.05 | |
| Total | 187.05 | 187.05 |
As can be seen the principal repayment is 176.46 which is the cash payment of 187.05 less the interest expense of 10.59.
Loan Repayment Journal Entry Explained
Debit
It is important to realize that in each of these journals there are two debit entries. Firstly the debit to the interest expense records the accounting entry for interest on the loan for the year calculated at 6% on the beginning balance. Finally the debit to the loan account records the reduction in principal of the loan balance which is the cash payment less the interest expense.
Credit
Cash has been used to make the annual payment to the lender on the due date in accordance with the loan agreement.
Loan Accounting Equation
The accounting equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities plus the equity of the business This is true at any time and applies to each transaction. For this transaction the accounting equation is shown in the following table.
To illustrate using the repayment for year 1 shown above as an example.
In this case an asset (cash) decreases as the repayment is made to the lender. On the other side of the equation a liability (loan) decreases representing the reduction in the loan principal, and the interest expense reduces the net income, retained earnings, and therefore the owners equity in the business.
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About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.