Question

Pick one of the four loan repayment options listed below and briefly discuss the benefits and detriments of that option versus the others.

1.     Equal Payments: Payment is constant and loan balance is gradually paid off over the term

2.     Equal Principal Payments: Principal payment is constant throughout the term of the loan

3.     Balloon Loan: Partial repayment of loan throughout the term of the loan

4.     Bullet Loan: Interest only loan, with principal due at maturity

Answer 1

A loan repayment schedule is illustrated in the image below. Let's pick balloon payment option for comparison

Equal payment - It has a fixed payment each period. Initially, a large portion of the repayment goes towards servicing the interest and small portion services the principal, which gradually changes over the period. In other words, the principal is amortized over the period of the loan.

Equal principal payment - It has equal principal payments over the tenor of the loan. The loan repayment is front-loaded, which means that the amount of repayment is higher at the beginning and reduced over time.

Bullet payment - In this only the interest is paid during the tenor and no principal is repaid. The entire principal is repaid at maturity.

Benefits of balloon payment

1. As you can see there is very little principal repayment initially. Major portion of the repayment is just the interest. Hence it helps the borrower to borrow more than what she could have been able to borrow otherwise
2. If the borrower intends to finance an asset through balloon loan and anticipates a price appreciation through the tenor, he can just pay the interest during tenor and liquidate the asset to repay at the end of the tenor

Detriments of balloon payment

1. Inability to raise funds to pay most of the principal at the end of the tenor can lead to default
2. If the asset prices fall or asset becomes illiquid, it may become difficult to service the debt and may lead to default

Loan amount (S) 10,000 Loan period (years) 10 Interest rate 10% Equal payments Interest Principal Oustanding paid Equal principal payments Interest Principal Oustanding repaid 1,000 Balloon payments Interest Principal Oustanding repaid principal Bullet payments Interest Principal Oustanding repaid Repayment Repayment Repayment Repayment paid repaid principal principal paid paid principal 9,373 2,000 1,000 Year 1 1,627 1,000 627 9,000 1,100 1,000 100 9,900 1,000 1,000 10,000 Year 2 1,900 1,000 1,000 1,627 937 690 8,682 900 1,000 8,000 1,090 990 100 9,800 10,000 800 Year 3 1,627 868 759 7,923 1,800 1,000 7,000 1,080 980 100 9,700 1,000 1,000 10,000 7,088 1,000 10,000 Year 4 1,627 792 835 1,700 700 1,000 6,000 1,070 970 100 9,600 1,000 600 5,000 1,000 10,000 Year 5 1,627 709 919 6,169 1,600 1,000 1,060 960 100 9,500 1,000 5,159 1,000 4,000 1,050 9,400 1,000 Year 6 1,627 617 1,011 1,500 500 950 100 1,000 10,000 1,627 Year 7 516 1,112 4,047 1,400 400 1,000 3,000 1,040 940 100 9,300 1,000 1,000 10,000 1,300 300 2,000 1,030 Year 8 1,627 405 1,223 2,825 1,000 930 100 9,200 1,000 1,000 10,000 1,000 Year 9 1,627 282 1,345 1,480 1,200 200 1,000 1,020 920 100 9,100 1,000 1,000 10,000 10,010 1,627 1,480 1,100 100 1,000 11,000 Year 10 148 910 9,100 1,000 10,000