Interest Only Loans

A second type of loan repayment plan calls for the borrower to pay interest each period and to repay the entire principal (the original loan amount) at some point in the future. Loans with such a repayment plan are called interest-only loans. Notice that if there is just one period, a pure discount loan and an interest-only loan are the same thing.

For example, with a three-year, 10 percent, interest-only loan of $1,000, the borrower would pay $1,000 X .10 = $100 in interest at the end of the first and second years. At the end of the third year, the borrower would return the $1,000 along with another $100 in interest for that year. Similarly, a 50-year interest-only loan would call for the borrower to pay interest every year for the next 50 years and then repay the principal. In the extreme, the borrower pays the interest every period forever and never repays any principal. As we discussed earlier in the chapter, the result is a perpetuity.

Most corporate bonds have the general form of an interest-only loan. Because we will be considering bonds in some detail in the next chapter, we will defer a further discussion of them for now.

0 0

Post a comment