CFA Level I · CFA Level I Exam · The Time Value of Money in Finance
For a fully amortizing loan with equal periodic payments and a fixed interest rate, how does the composition of successive payments most likely change over the life of the loan?
The interest share falls and the principal share rises. Interest is calculated on the outstanding balance, which shrinks with each payment, so with a constant total payment a growing part of each payment goes to repaying principal.
- AInterest share falls and principal share risesCorrect
- BInterest share rises and principal share falls over time
- CBoth shares stay constant because the total payment is constant
Explanation
Interest each period is the rate times the outstanding balance. Because the balance declines as principal is repaid, interest falls. With a constant total payment, the principal portion must therefore rise. A constant total payment does not imply constant components.
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