Interest-Only Period: a Worked Example

A term loan normally starts repaying at once, on the view that the asset it paid for is already earning. Sometimes that is untrue. A factory being fitted out earns nothing until it is commissioned. A newly planted orchard may take years to bear a commercial crop. In those cases a schedule of full instalments would ask the business to repay out of earnings that do not yet exist, and a period of interest alone fits the debt to the asset.

The same words describe a different event when the period is granted later, to a business through a poor year. The first is a design decision, made before any money moved. The second is a concession, made because the original schedule cannot be met. A lender reads the two differently, and a US supervisor's handbook makes the general point about property loans: interest-only terms can lower the chance of payment default while raising the loss if default comes, and the risk at maturity.

Three terms set the result. The first is the length, which decides how much of the term is left to do the repaying. The second is whether the final date stays put. If it does, each month of interest-only compresses the repayment into less time and raises the later instalment. If the term is lengthened instead, the instalment stays lower but the exposure lasts longer. The third is whether the interest is actually paid. A loan on which interest is added to the balance grows; that is capitalised interest, and it is a heavier concession than the one on this page.

A recycler of plastic food packaging, constructed for this page like every figure in it, borrows US$9.0m over ten years at a fixed 7.5%, paid monthly, to build a washing and pelletising line. The bank compares repayment from the first month with 24 months of interest only. The rate, the term and the ramp-up belong to the example.

The case for the period is in the first two columns: full instalments cannot be met while the line ramps up. Its price is US$525,873 of extra interest and a higher instalment later, and year 3 shows the point of tension, when the business must earn about 46% more than in year 2 just as its payments more than double. Suppose commissioning slips a year, so that year 3 earns only US$1.30m. Cover on the US$1.50m instalment would be 0.87 times, and the recycler asks for a third year of interest only, keeping the final date:

The third year solves year 3 and tightens every year after it. Nothing has been repaid after 36 months, and the instalment waiting at the end has risen again.

An interest-only period is a stretch of a schedule. A bullet repayment is what results if the stretch runs the whole life of the loan. A balloon may follow an interest-only period or an amortising one, and describes what is left at the end. A payment holiday, by contrast, may stop interest as well, which then accrues.

It also changes what a ratio says. While the period lasts, debt service is interest alone, so debt service cover tells a reader little beyond what interest cover already does and says nothing about the capacity to repay. Reading the file on an as-if-amortising basis restores what the low payment hides.

DEFINED IN ONE PARAGRAPH → · THE TERM LOAN FILE → · AMORTISATION →

At origination the question is what ends the period. A lender wants an event it can check, such as commissioning or a first commercial crop, and a test of the later instalment on realistic earnings. That same US handbook expects commercial property loans to meet the bank's cover requirements as though amortising, and many lenders elsewhere run the same second calculation as a matter of policy. Where the period is long, a reduced loan amount, a reserve or a cash sweep can stand in for the repayment that is not happening.

Later, the question is why a further period is being asked for. A delay with a known cause and a new date is one thing. A business whose earnings have reached plan and still cannot carry the instalment is telling the lender something about the debt itself. Granted to a borrower in difficulty, the concession carries consequences inside the bank: Australian prudential rules list rescheduled payments, grace periods and deferred principal among the concessions that make an exposure restructured, and lenders in New Zealand and the UK apply their own forbearance definitions. A dairy farm given a season of interest only after a low milk price is the familiar case.