How to properly record a loan payment

If you are like many businesses, you may have one or more loans on which your business makes regular payments. Write a check, and the payment is made! But are you doing the bookkeeping side of your loan payments correctly? Let's take a look!

What I see all too often is someone making a payment on their business loan, and then either showing the entire amount as an expense, or as a reduction in the loan amount.

Either of those is definitely the wrong way to do it!

When you obtain a loan, it generally comes with a document called an amortization schedule. (If the loan paperwork doesn't come with such a document, ask for it!) Amortization refers to the process of paying off a debt over time through regular payments. The loan amount may also be called the principle.

An amortization schedule shows the details of the loan: the original loan amount, the interest rate, the term over which payments are to be made, and the amount of each payment. This payment amount is further broken down to the portion applied to the loan (principle) balance, and the portion that is interest.

Since the payment consists of two portions, is makes sense those portions are recorded differently. So choosing to show the payment as all expense or as all debt reduction would be wrong.

Instead, when making the payment, usually via writing a check, the principle amount is recorded as a reduction of the debt, and the interest is recorded as an expense.

And, since loans and their associated payments vary widely, depending on the principle amount, the interest rate, and the term, the amortization schedule shows that the principle and interest amounts change slightly with every payment. Therefore, though each payment is the same amount, the way it is divided between principle and interest changes.

By the way, at the end of your business year, compare the loan balance on the Balance Sheet with the amortization schedule's balance on the date in question. If they don't agree, a payment was probably recorded improperly. Now you know how to correct it!

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