Question

pure discount loans, interest-only loans, amortized loans, and balloon loans. What do each of those categories mean and please provide a real-life example of when each could be an appropriate method of financing.

Answer 1

Pure-Discount Loans

In a pure discount loan, the borrower receives money today and makes one lump-sum payment at some time in the future.

Consider, for example, a T-bill that promises to pay $1,000 in one year. When the interest rate is 3.48%, the value of this T-bill is PV = 1,000 1.0348 = $966.37. If the repayment (L) takes place after t periods, the present value of the loan is PV = L (1+r) t .

  Interest-Only Loans

  With this type of loan, the borrower pays interest each period and repays the principal at some point in the future. Take, for example a 5-year loan of $1,000 at an 8% annual interest rate.

Each year the borrower pays $80 in interest and the principal ($1,000) is repaid after 5 years. Cash flows to the lender are then

  The present value of the above loan, at a discount rate r, is PV = 80 r à 1− µ 1 1+r ¶5 ! + 1,000 (1+r) 5 . Note that PV    > $1,000 if r < 8%, = $1,000 if r = 8%, < $1,000 if r > 8%.

  Amortized Loans

  An amortized loan is such that interest and principal are repaid each period. This type of loan can be such that a constant amount of the principal is repaid each period, or can be such that a constant payment is made each period.

How long would it take to repay a $5,000 loan with an APR of 10% compounded monthlyif $500 in principal has to be repaid each month?

   balloon loans

A balloon loan is a type of loan that does not fully amortize over its term. Since it is not fully amortized, a balloon payment is required at the end of the term to repay the remaining principal balance of the loan. Balloon loans can be attractive to short-term borrowers because they typically carry lower interest rates than loans with longer terms. However, the borrower must be aware of refinancing risks as there's a risk the loan may reset at a higher interest rate.