What is an Interest-Bearing Loan?
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Summary:
Interest-bearing loans consist of money loaned from one party to another, in which the lender collects interest on top of the principal amount that they loaned. Interest-bearing loans can last for different time frames and use different structures to charge interest. Interest-bearing loans are the primary form of debt, which is vital to modern economic growth.
Debt is an important lubricant for the gears of the modern economy and global financial systems. Companies or individuals often desire money to invest but only have a set amount of capital they can invest themselves. In order to solve this problem, they will borrow money from a third party. This third party needs something in return for taking the risk of lending money. The lender, in most cases, will charge interest on the amount of money they loan out. Interest, in this case, is a percentage of the principal loan that is charged on top of that principal. The borrower is required to pay back both the loan and the interest, in some form or another.
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Interest-bearing loan history
Interest-bearing loans have a rich and complicated history. The Catholic Church, for a period of time, forbade interest from being charged on money as a way to make a profit. Islamic finance works similarly. Earning money based on loans and interest is forbidden or “haram” in Islam. So a whole industry of banks and funds has sprouted up in the Islamic world, offering a structure to go around this.
Interest-bearing loans and the usage of debt in modern economics represent a momentous leap in the ability to grow an economy. Although interest-bearing loans have the same cornerstone — principal + interest — they can take on a variety of different forms and structures.
Interest-bearing loans 101
Interest-bearing loans have four elements that are omnipresent: a lender, a borrower, principal, and interest.
Lender
A lender is an entity that loans out money. In many cases, the lender is a bank. But they can also be an assortment of different operations, such as a credit union, a fund, financial institutions, the government, your mother, or your best friend Pablo from childhood. They are the ones sending the money to a third party.
Borrower
A borrower is a company or individual who receives money from a loan. A borrower might want a loan for a variety of reasons. A company might want to invest in a certain product and thus needs to borrow money to finance the research and development. An individual might want to buy a house and can make monthly payments but cannot afford to pay all the money upfront. Whatever the reason, the borrower is on the hook for the money sent to them by the lender and they will be the one that pays interest.
Principal
The principal is the amount of money borrowed. For instance, say you want to buy a house for $100,000. You put 30% down, which is $30,000. You then need to borrow the additional $70,000. This $70,000 is the principal. Regardless of any fees, interest, or additional closing costs that are not financed, the principal is always simply the amount of the loan you receive.
Interest
Interest is a percentage of the principal that the borrower pays the lender in addition to that principal. In exchange for taking on the risk and spreading out your repayment over time, the lender charges interest. For example, if you buy a home that costs $100,000 and take out a $70,000 loan, you need to pay interest in addition to the $70,000. If the lender wants, for instance, $70,000 + 10% interest ($7,000), the borrower needs to pay the lender $77,000.
Interest-bearing loan structures and time frame
Interest-bearing loans can take on different payment structures and different time frames, depending on the type of loan.
Interest-bearing loan time frames
An interest-bearing loan can be either a short-term loan or a long-term loan. When the loan reaches the date that it is due to be paid back, it reaches its maturity date. Different loans have different maturity dates, depending on what and who they are for. It could be five years for an auto loan or 30 years for a mortgage.
Furthermore, interest-bearing loans have payment schedules. These payment schedules determine how much of the loan you are supposed to pay back, how much interest you owe, and when it is to be paid. Many interest-bearing loans feature something called amortization.
Amortization
Amortization is a structure in finance in which the payment of a whole loan or piece of debt is gradually reduced. The idea is that the loan is spread out over a period of time. With the first monthly payment, the borrower pays interest on the full principal amount of the loan. The next month, the principal is reduced by one payment, so the interest is a little lower. Over time, the amount of the monthly payment going to principal gets higher and higher while the amount going to interest gets lower and lower.
For instance, let’s say that you have a company taking out a loan of $100,000 plus 10% interest for a total of $110,000 over two years. That $110,000 will be split up over time, in, say, monthly payments, rather than a lump sum. This lets the lender alleviate risk, as the borrower is considered more secure if they are required to meet monthly payments with more interest paid upfront.
Types of interest-bearing loans
Mortgages
Mortgages are the most common interest-bearing loans that people will take out in their lifetimes. If a person wants to buy a property but doesn’t have the capital to pay for it all upfront, they will need to borrow money from a lender, such as a bank. The interest rates in mortgages are generally some of the lowest because the loans are secured, and the house acts as collateral. This means that if the buyer fails to meet the loan obligations, the lender can seize the property. In most cases, the borrower must make monthly payments. Banks typically offer two types of mortgages: capital + interest and interest-only loans.
Pro Tip
If you have an amortized mortgage, it’s a good idea to review the principal vs. interest amounts from your first payment to the last payment over the term of the loan. This way you can significantly increase your knowledge of your cash flow now, and in the future.
Capital + interest mortgages
In a capital or principal + interest mortgage, you make monthly payments that represent a mix of both the principal loan you took out plus the interest due. The bank will give you an amortization schedule that explains when and how much you need to pay. Once a capital + interest loan reaches maturity and is paid off, the buyer now owns the property 100% without any encumbrances. However, capital + interest mortgages are more expensive than their interest-only counterparts, at least in the beginning.
Interest-only mortgages
Interest-only mortgages mean what they sound like — you only pay the interest for the first several years of the loan. During this interest-only period, your monthly payment will be lower than for someone with a principal + interest loan. But when that period ends, your payment will jump significantly as you have to start paying both principal and interest. Interest-only loans are best for short-term situations, such as investment properties. They are really only beneficial in a liquid market in which you can sell quickly, based on a rise in value.
Bridge loans
Bridge loans are short-term loans used to bridge gaps in payment. For individuals, they are most commonly used when someone wants to buy a new house before they’ve sold their current one. The interest on bridge loans is typically higher than other types of loans. And you will need to have a certain amount of equity in your home and good credit to qualify for the loan.
Student loans
Student loans are another prevalent type of interest-bearing loan. Many student loans are backed by the federal government and thus have low interest rates. In many cases, student loans will have a very different payment structure than other traditional loans. Typically they do not need to be paid back until a student graduates and can be deferred for a period of time after graduation.
Consumer loans
Credit card debt and car loans are examples of common interest-bearing loans that help consumers buy normal goods, such as cars and merchandise. The borrower will pay the principal and any interest owed. Any late or missed payments on these loans, however, could result in either your credit score being crushed or your auto being confiscated.
Interest rates and the Fed
A majority of loans made in the United States are tied to the interest rate of the US’s central bank, the Federal Reserve. The Federal Reserve uses what they refer to as basis points to set an interest rate. Basis points represent a fraction of a percent out of 100. If an interest rate rises by 50 basis points, it rises by .5 percent. Most lenders will track the interest rates the Fed releases and change their retail interest rates in tandem.
For instance, if the Fed’s interest rate is 1%, this means it costs banks 1% to borrow money from the Federal Reserve. Banks then charge an additional percentage of interest to the end borrower on top of the Fed’s interest rate. For instance, some banks will offer 3% above the Fed rate. In the case of the Fed rate being 1%, the bank will offer 4% interest on a loan. The graph below explains how mortgage rates in the United States track the Fed Rate.
Interest-bearing loans are bought and sold
Interest-bearing loans, also called interest-bearing debt or just debt, can be sold to third parties as well. For instance, let’s say that you take out that $70,000 from the bank for your mortgage. The bank then can sell the mortgage contract that they have with you to a third party. The borrower is still under contract to pay the principal plus any interest. But now the third party can be the beneficiary rather than the original bank. Interest-bearing loans in the form of debt are bought and sold through the global financial markets on a daily basis.
FAQ
How are interest-bearing loans calculated?
Interest-bearing loans are calculated by charging a percentage of the principal that was borrowed. The borrower pays back both the principal and the total interest charged.
Can I pay off an interest-bearing loan early?
Yes, you can pay off an interest-bearing loan early. Some financial institutions will charge a fee if the loan is paid off before the due date, but this is rare.
What is the best way to pay off an interest-bearing loan?
The best way to pay off an interest-bearing loan is with monthly payments, according to the payment schedule from your lender. However, if you are able, you may benefit from paying a little extra each month towards the principal of the loan.
What is an interest-bearing note?
An interest-bearing note is a financial instrument that represents a loan plus the interest or simple interest charged.
Key takeaways
- Interest-bearing loans are loans in which one party lends money to another and charges interest, which represents a percentage of the loan’s principal amount.
- An interest-bearing loan has four elements: a lender, borrower, principal, and interest.
- Interest-bearing loans can differ in their time frames, and most are subject to some type of amortization.
- When the Fed raises its interest rate, the retail interest rates available for borrowers will usually change in tandem.
- Interest-bearing loans are sold every day in the form of interest-bearing debt.
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