Interest-Only Versus Blended Interest-Principal Loan

You have approached the bank for a $50,000 loan for Daisy Ltd. The bank offers you two options. Both of these options have an interest rate of 6% payable semi-annually and a term of three years. Your options are:

Principal Plus Interest LoanPrincipal Plus Interest Loan:
Consists of contractual cash flows for interest paid over time plus payment of the loan principal at the end of the loan term. Corporate bonds are an example of this type of loan. To contrast, see blended interest-principal loan..

Every six months, you will make an interest payment in cash. At the end of the three-year term, you will pay back the principal.

Blended Interest-Principal LoanBlended Interest-Principal Loan:
Consists of set cash payments each period that are partly loan interest, and partly repayments of loan principal. As the loan term continues, interest constitutes a smaller percentage of the cash loan payment. Mortgages are designed as blended interest-principal loans. To contrast, see Principal plus interest loan..

You will make a payment of $9,230 every six months. Part of this payment will be interest, and part will be principal.

Your banker makes it clear that the first option will cost you more in interest, but it will allow you more cash flow flexibility because your monthly payments will be smaller. You note that in three years you’ll have to come up with the principal amount, but maybe you could just get another loan when the principal is due. To make your decision, you (wisely) create an Amortization TableAmortization Table:
A tool designed to track contractual cash flows and accounting adjustments required for loans over the debt term. An amortization table includes columns for opening balance, interest paid, total cash paid, principal repayments, and closing balance. See also: blended interest-principal loan, principal plus interest loan. for the two loan options so you can compare the cash flow implications and total interest paid on the loans.

You remember from your accounting class that the interest rate given by the bank is an annual rate, but interest payments happen every six months. Because you will be paying interest twice per year, you need a rate that reflects this payment schedule. Of course, the 6% interest rate can be expressed as a 3% semi-annual rate (6% × 6/12 months). Now that you have a semi-annual interest rate, you have all the information you need to continue with the amortization table.

i:

interest rate

n:

the number of periods in the loan term

Total Cash Flows for Principal and Interest:

This may have to be calculated.

Option 1:

Principal plus interest loan. This loan pays interest only over the term of the loan with the $50,000 principal repaid at the end of the term. i=3%, n=6 periods (3 years × 2 payments per year), semi-annual cash flow for interest = 3% × $50,000 = $1,500.

Take a look at this amortization table. It is set up with 6 periods, where period 0 is the date the loan is taken out. The second column is the opening balance which is equal to the closing balance from the previous period. In this example, because there are no principal repayments, interest paid is $1,500 every period, calculated as $50,000 × 3%.

*Period 0 is the date the loan is taken out.

Option 2:

Blended interest-principal payments. This loan requires cash paid of $9,230 every period. Some of this cash paid will be for interest, and the rest is principal repayment. i=3%, n=6 periods (3 years × 2 payments per year), semi-annual cash payment = $9,230.

Take a look at this amortization table. The set up is identical to option 1, but this time principal is repaid every period, so the closing principal balance owing goes down over time: calculated as opening balance minus principal repayment. Notice that interest paid is $1,500 in the first period, and then gets lower over time. This is because interest paid is based on the opening principal balance, so the second period interest paid is calculated as $42,270 × 3%. As the opening principal balance goes down, so does the interest payment.

Your amortization analysis is super helpful! Let’s analyze it.

Total Interest Paid on the Loan:

• Option 1: $9,000 ($1,500 × 6)
• Option 2: $5,398 (1,500 + 1,268 + 1,029 + 783 + 530 + 270)

Semi-annual cash payments: lower under option 1 ($1,500 versus $9,230), so cash flow risk is lower, but no principal has been paid. This means that $50,000 is still owing under option 1, but no remaining payments are required for option 2.

In considering your options, you note that option 1 results in lower cost of debt because interest paid is less. But option 1 is also risky. It requires higher cash payments than option 1, and therefore a greater risk of default if the company can’t pay the $9,230 required each period.

Let’s complete some more problems. I’ll do the first one, and then it’s your turn.

My Turn:

Good Eats is a small restaurant business. They are taking out a loan for $80,000 to upgrade their commercial ovens. The bank has offered them two options for the loan. Both options have an interest rate of 8% payable quarterly over a term of 2 years.

Because the interest is payable quarterly, the interest rate can be expressed as a 2% quarterly rate (8% × 4/12months). We will have 8 payments (2 years × 4 payments yearly).

Here are our inputs: i=2%, n=8, quarterly cash flow for interest = 2% × $80,000 = $1,600

Let’s tackle this problem in three steps:

1. Create an amortization table for the principal plus interest option.
2. Create an amortization table for the blended interest-principal option using a quarterly payment amount of $10,921
3. Calculate total interest paid for each loan option. Which option allows Good Eats Inc. to pay less interest?

1. Amortization Table: Principal Plus Interest Loan:

   Period	Opening Balance	Interest Paid (3% × balance)	Total Cash Paid	Principal Repayment	Closing Balance
   0					80,000
   1	80,000	1,600	1,600	—	80,000
   2	80,000	1,600	1,600	—	80,000
   3	80,000	1,600	1,600	—	80,000
   4	80,000	1,600	1,600	—	80,000
   5	80,000	1,600	1,600	—	80,000
   6	80,000	1,600	1,600	—	80,000
   7	80,000	1,600	1,600	—	80,000
   8	80,000	1,600	1,600	80,000	—

2. Amortization Table: Blended Interest-Principal Loan:

   Period	Opening Balance	Interest Paid (3% × balance)	Total Cash Paid	Principal Repayment	Closing Balance
   0					80,000
   1	80,000	1,600	10,921	9,321	70,679
   2	70,679	1,414	10,921	9,507	61,172
   3	61,172	1,224	10,921	9,697	51,475
   4	51,475	1,030	10,921	9,891	41,584
   5	41,584	832	10,921	10,089	31,495
   6	31,495	630	10,921	10,291	21,204
   7	21,204	424	10,921	10,497	10,707
   8	10,707	214	10,921	10,707	—

Total Interest Paid for Each Option. Interest paid for Option 1 is higher than Option 2.

• Option 1: $14,400 ($1,600 × 8)
• Option 2: $7,368 ($1,600 + $1,414 + $1,224 + $1,030 + $832 + $630 + $424 + $214)

Let’s give it another try. This time you do the calculations!

Well done! Let’s get a bit more practice in because debt calculations are so important. Here you go…

Great progress! Thanks for moving through these exercises! Now let’s move from calculations to journal entries.