A non-amortizing loan is a loan where the principal owed does not get paid until the loan is due. Non-amortizing loans are also referred to as interest-only loans or balloon-payment loans.
Understanding Non-Amortizing Loans
A non-amortizing loan does not come with an amortization schedule. Typically, a loan’s principal will get paid back in installments. For example, most house mortgages are paid in this way. However, the principal on non-amortizing loans is paid back in a lump sum.
Principal refers to the original amount of money borrowed in a loan or the face value of an investment. It is the amount of money invested that is expected to be paid back in the absence of a profit. However, investments are made with the expectation of receiving a profit. The profit comes from the interest portion of a loan. Interest is the amount that a lender will charge a borrower to borrow their money. It is typically expressed as an annual percentage rate (APR).
With a non-amortizing loan, there is no payment schedule and no concept of prepayment. A borrower must only make minimum scheduled payments. For example, most credit-card loans are structured as non-amortizing loans. With credit-card loans, you are lent money to make purchases, and instead of having to pay back the principal in a clear schedule, you only must make minimum monthly payments.
The amount of principal is reduced or increased depending on how much interest is being accrued and the amount of the lump-sum payments. When a borrower makes a payment that is smaller than the accrued interest, the balance of unpaid interest increases the debt principal. Conversely, when a borrower makes a payment that is larger than the accrued interest, the excess balance decreases the debt principal.
Characteristics of a Non-Amortizing Loan
Non-amortizing loans are characterized by their short duration and a high interest rate associated with them. The higher interest rate is compensation for the additional risk being taken on by the lender. The additional risk can be explained with an example.
Consider there is $1,000 that you are willing to lend out. Two potential borrowers are proposing the following:
The first borrower proposes an amortizing loan where they will pay you back $250 every quarter at a 5% interest rate.
The second borrower proposes a non-amortizing loan where they will pay you back $1,000 at the end of the year at a 5% interest rate.
Which borrower will you prefer?
A rational lender will prefer to lend to the first borrower. No matter which borrower is chosen, the amount of interest received will be the same. However, there is the added security of receiving the principal in installments. If the borrower were to default halfway through the year, with the first borrower, at least you would’ve already received $500 of the principal payments.
However, with the second borrower, you would lose your entire principal investment if the borrower were to default halfway through the year. in addition, considering the time value of money, receiving the principal earlier is preferable to later, as you can invest the principal received and earn additional interest.
In conclusion, the second borrower needs to compensate by offering a higher interest rate on the loan.
Types of Non-Amortizing Loans
There are three general types of non-amortizing loans:
1. Interest-only loan
An interest-only loan is a loan where the borrower pays only the interest throughout the term of the loan, with the principal being left unchanged.
2. Deferred-interest loan
A deferred-interest loan is a loan where the interest payments are deferred for a period of time. Therefore, there will be no interest charge as long as the loan is paid off before the end of the period.
3. Balloon-payment loan
A balloon-payment loan is a short-term loan that is set up with a large final payment at the end of the term.
The loans do not require any principal payments to be made throughout the life of the loan. Some of them require the interest to be paid in installments, whereas some of them require the interest to be paid in a lump sum in addition to the principal.
Non-amortizing loans are used in situations where there is limited collateral available to borrowers. It can be for a credit card loan, a home equity line of credit (HELOC), other lines of credit, land contracts, or real estate financing.
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