Definition: An installment note is an obligation or liability that requires the borrower to repay the principal to the lender in a series of periodic payments. In contrast, a lump sum note or balloon loan requires that the borrower repay the entire note principal at a specific date. There is no payment plan.
What Does Installment Note Mean?
An installment note, on the other hand, typically has a payment schedule where the borrower repays the lender in equal payments monthly, quarterly, semi-annually, or annually until the loan is fully repaid with interest. It works the same way a person mortgage works. There is a note term and a set payment amount that will be paid equally throughout the term.
These types of notes are common among franchises and businesses that require trade debts to float their inventory over several accounting periods.
Let’s look at an example.
Example
Tim’s Brewery needs to finance its newest expansion and doesn’t want to use equity financing, so it takes out a loan with its local bank. Tim gets a 5-year $100,000 loan to add on to his factory records the note with a debit to cash and a credit notes payable.
The note terms include a 10 percent interest rate and monthly payments. Tim will make a monthly payment of $2,125. This payment amount includes the 10 percent interest charged every month.
Just like a personal mortgage, the installment note payments will first be made predominantly of interest payments. Toward the middle of the third year, a larger amount of the payments will go against the principal of the note.
At the first of each month, Tim will post a journal entry to record the loan payment by debiting the notes payable and interest expense account and crediting the cash account.
