Repayment loan
A repayment loan is a common form of loan with constant principal repayments. Constant principal repayment in this case means that the principal portion paid to the bank each month always remains the same. Interest is then added and recalculated with each instalment. Because the outstanding balance continuously decreases, the amount paid monthly in interest also decreases accordingly. As a result, the total payment falls increasingly over time. Toward the end of the term, the interest portion is usually very small. The repayment loan aims for the greatest possible reduction of the outstanding balance at the beginning of the term. Overall, this makes it cheaper compared with, for example, an annuity loan. A drawback is the high initial burden due to the still relatively large interest amounts at the start. The repayment loan is also referred to as an instalment loan or amortizing loan.
Distinction from other loan types
Other common loan types are annuity loans and bullet (interest-only) loans. The differences mainly concern the instalment payments. With an annuity loan, the interest and principal portions change so that the same total instalment is paid each month. With a bullet loan, the outstanding balance is only fully repaid at the end of the term. This is usually done with the help of a repayment vehicle such as an endowment life insurance policy, pension insurance or a home savings contract (Bausparvertrag). A known application form is the so-called civil servant loan.
Key comparison factors for loans
One of the most important comparison factors for repayment loans is the effective interest rate (also known as the annual percentage rate). This indicates the actual costs incurred in connection with the loan or its uptake. Cost-relevant factors such as processing fees, instalment amount, term and discount (disagio) are included here. The disagio is also referred to as a "hidden interest" but at the same time as prepaid interest. This means a lower disbursed amount. In practice, typically between 90 and 95 percent of the nominal loan amount is disbursed, while the full 100 percent is used as the basis for interest calculation. The effective interest rate is based on the nominal interest rate. The latter is the price for the loan itself and is oriented in amount to reference interest rates. Both the effective rate and the nominal rate must be disclosed for every loan offer in accordance with the Preisangabenverordnung. This provides customers with greater market transparency. For comparisons, the effective interest rate should be used, since it allows the actual costs of loans to be compared with one another. However, it should be noted that there are other important factors in selecting a loan besides the interest rate. This applies in particular to term and instalment amount. With a repayment loan, the instalments are variable but decrease over time. This is due to the declining interest portion, while the principal portion remains constant from start to finish. Deviations can occur if special payments are made in the meantime that aim not to shorten the term but to reduce the instalments. Borrowers should always keep in mind that especially long-term loans must be aligned with the household budget. This means that the income and expenditure situation should be known in order to avoid major cuts in quality of life or even sustained financial bottlenecks. For repayment loans this is especially relevant at the beginning of the term, since the individual instalments are higher here than, for example, with an annuity loan. Because repayment loans are usually medium- to long-term loans with terms of a few to several years, the fixed-interest period is also an important factor. Private customers in particular are mostly granted repayment loans with a fixed interest rate for the entire term. This offers the major advantage that the budget can be planned more reliably over the relevant period. Although the individual instalments do not remain the same size as with an annuity loan, they can at least be calculated in advance. In addition, the instalments of a repayment loan fall month by month. Repayment loans with variable interest rates can, however, of course be cheaper. That depends on current developments in the capital market and therefore always has a speculative character. Consumers with less market knowledge are therefore generally advised to opt for a loan with fixed interest rates.
Pros and cons compared with annuity loans
Repayment loans are frequently used in practice for commercial real estate financing. Private individuals, on the other hand, tend to use annuity loans more often because they offer better predictability. The advantage in commercial real estate financing lies in the higher deductible interest, which helps to offset the calculated loss in value. Another advantage of the repayment loan is the greater flexibility regarding early repayment of the loan amount. Planning an annuity loan involves considerably more effort. In addition, a comparatively large share of interest and principal is repaid already at the beginning of the term, which reduces the bank’s lost profit and thus also reduces the prepayment compensation (Vorfälligkeitsentschädigung) that the customer must pay.
When is a repayment loan appropriate?
Depending on what the loan is to be used for and what term is to be expected, both annuity loans and repayment loans can be more advantageous. Customers who are in a financial position to accept a relatively high burden at the beginning may be recommended a repayment loan. This reduces the overall interest expense, since a large portion of the outstanding balance is repaid early on. With an annuity loan, interest payments always predominate at the beginning, while the principal portion only increases slowly over time. Those who, on the other hand, value equal instalments to improve predictability for their household budget should opt for an annuity loan. In this regard, the advantage of a larger supply should also be mentioned: most consumer loans offered by banks and credit institutions in a wide range of conditions are annuity loans. If both options are available, it is primarily a question of calculation and the financial capacity in the initial phase. An alternative would be to agree an annuity loan with a down payment. This is particularly common in vehicle financing.