Understanding Interest Charges on Installment Agreements

Overview

When you can’t pay your federal tax bill in full, an IRS installment agreement lets you repay the balance over time. That flexibility comes at a cost: interest. The IRS charges interest on unpaid taxes (and generally on penalties too) until the debt is paid. Interest is compounded daily and the rate is adjusted quarterly based on the federal short‑term rate plus 3 percentage points (IRS, “Interest on Underpayments and Overpayments”).

This article explains exactly how those interest charges work, shows simple ways to estimate the cost, and gives practical strategies I use in practice to reduce interest exposure for clients.

Sources: IRS — Payment Plans (Installment Agreements) and IRS — Interest on Underpayments and Overpayments (see IRS.gov).

Why the interest charge matters

Interest turns a manageable tax balance into a much larger long‑term cost. Even modest rates, when compounded daily, add up quickly. Two common misconceptions I see: 1) taxpayers assume penalties are the only added cost, and 2) they underestimate how daily compounding increases total interest versus a simple annual calculation.

Interest compounds on the outstanding balance, and because interest itself can be charged interest (daily compounding), paying only the minimum monthly amount often stretches payments and raises the total cost substantially.

For related guidance on the types and costs of installment agreements, see FinHelp’s guide: IRS Installment Agreements: Types, Costs, and Application Tips.

How the IRS calculates interest (simple explanation)

Key points:

• The IRS posts a quarterly interest rate. The statutory methodology is the federal short‑term rate plus 3 percentage points (26 U.S.C. §6601).
• Interest is compounded daily.
• Interest accrues from the original due date of the tax until the date the IRS receives the full payment.
• Interest is generally charged on unpaid tax, on certain penalties, and on previously assessed interest.

Basic formulas:

• Daily rate = annual interest rate / 365.
• Daily compounding growth after n days = principal × (1 + daily rate)^n.

Example (hypothetical):

• Starting balance: $10,000
• Annual interest rate (hypothetical): 6% (0.06)
• Daily rate = 0.06 / 365 ≈ 0.0001644

After 365 days without payments the balance ≈ $10,000 × (1 + 0.0001644)^365 ≈ $10,618 (about $618 interest).

Note: The IRS posts actual quarterly rates on its website. Always check the current rate at the IRS interest page for exact numbers.

How interest interacts with penalties and payments

• Interest applies to the unpaid tax balance first and also applies to most penalties assessed (for example, failure‑to‑file and failure‑to‑pay penalties). If a penalty is later abated, the base for future interest can change.
• When you make a payment, the IRS typically applies it first to penalties, then interest, then the tax (but allocation can vary by situation). That means early payments may be eaten by accrued interest and penalties rather than reducing principal.

For details on how penalties accumulate during installment agreements, FinHelp has a focused explanation: How Penalties Accrue During an Installment Agreement.

Simple amortization example to compare payment plans

This example uses a rounded, hypothetical rate for clarity. Because the IRS compounds daily, a full amortization schedule is slightly different, but monthly approximations are useful for planning.

Scenario A — Longer plan:

• Balance: $15,000
• Annual interest: 6% (hypothetical)
• Monthly payment: $300

Approximate monthly interest = balance × (0.06/12)

First month interest ≈ $15,000 × 0.005 = $75. A $300 payment leaves $15,000 + $75 − $300 = $14,775.

Over multiple months, the balance falls slowly and total interest paid can add thousands of dollars over years.

Scenario B — Shorter plan / lump sum or loan with lower rate:

• Same balance, but you pay $1,000 per month or secure a personal loan at 8% APR to pay in full. Even though loan interest is higher in this example, the shorter payoff period can reduce total interest compared to a long IRS installment because you stop daily compounding sooner.

Takeaway: compare total dollars paid, not only the monthly payment. If a reasonable bank loan has a lower effective cost or lets you pay the IRS in full, that option can save money.

For help building a realistic monthly payment, see FinHelp’s calculator guide: How to Calculate a Realistic Monthly Payment for an Installment Agreement.

Practical strategies to lower total interest costs

1. Pay as much as you can up front. The larger the initial reduction of principal, the less interest will accrue.

2. Shorten the repayment term. Higher monthly payments reduce the time interest compounds.

3. Consider a lower‑rate loan to pay the IRS in full. Compare the total interest and fees over the payoff period. Some clients with good credit find a personal loan cheaper than years of IRS interest (run the numbers carefully).

4. Monitor quarterly interest rates. If rates decline and you can accelerate payments during a low‑rate period, do so.

5. If penalties are a big part of your balance, pursue reasonable cause or first‑time penalty abatement where applicable; reducing penalties reduces the base on which interest accrues (see IRS penalty relief guidance).

6. Avoid default. Defaulting on an agreement can trigger collection actions and additional costs. If your financial situation changes, contact the IRS to modify the agreement rather than missing payments.

A note from my practice: I often advise clients to get a clear total‑cost comparison (IRS projected interest vs loan interest and fees) and a written repayment plan before deciding. Numbers can be counterintuitive — a slightly higher annual rate on a short bank loan can still save money by eliminating years of daily compounding at the IRS rate.

Common misconceptions and mistakes

• “Interest stops if I enter an installment agreement.” No. Interest continues to accrue until the balance is paid in full.

• “The IRS will negotiate the interest rate.” Generally no. The statutory rate is set by law and changes quarterly. What can be negotiated is the length and structure of payments in limited scenarios.

• “Only the tax owes interest.” Interest typically applies to penalties as well; reducing or abating penalties when appropriate reduces interest exposure.

• “A low monthly payment is harmless.” Low payments stretch the repayment period and increase total interest paid substantially.

When interest stops and special cases

• Interest stops accruing on the date the IRS receives full payment.
• If you successfully qualify for an Offer in Compromise, the resolved amount becomes your final amount due; interest behavior during OIC consideration can be nuanced — the IRS continues to charge interest up to the acceptance and may include interest terms in the OIC. Consult a tax professional when pursuing an OIC.
• Placing an account in Currently Not Collectible (CNC) status pauses active collection, but interest generally continues to accrue while the debt remains unpaid.

How to check current IRS rates and your account

• The IRS posts current interest rates and updates them quarterly: https://www.irs.gov/payments/interest-on-underpayments-and-overpayments
• To see how much interest you currently owe, review your IRS account online or the notice the IRS sent confirming the installment agreement. Consider requesting a payoff quote from the IRS for a specific date — that gives an exact figure to compare to outside loan offers.

Bottom line

Interest on IRS installment agreements is real money. It compounds daily, is set by statute (federal short‑term rate + 3 points), and continues until your tax debt is fully satisfied. Before accepting an installment plan, run scenarios: paying more now, shortening the term, or using an outside loan can sometimes save thousands. If you need help assessing options, consult a qualified tax professional.

Professional disclaimer

This information is educational and does not constitute legal, tax, or financial advice. Your situation may be different — consult a licensed tax professional for personalized guidance.

Authoritative sources

• Internal Revenue Service, Payment Plans (Installment Agreements): https://www.irs.gov/payments/payment-plans-installment-agreements
• Internal Revenue Service, Interest on Underpayments and Overpayments: https://www.irs.gov/payments/interest-on-underpayments-and-overpayments
• IRS Publication 505, Tax Withholding and Estimated Tax (for general interest/penalty guidance): https://www.irs.gov/forms-pubs/about-publication-505