Payment-in-kind (PIK) interest is an alternative to cash payments in which goods or services are used as debt instruments instead. Businesses often use PIK loans to preserve their cash flow when borrowing money. Loans that use payment-in-kind interest also give businesses flexibility by allowing them to adapt that PIK interest using partial cash payments or a PIK toggle.
The cost of borrowing money comes in the form of interest. Most of us pay interest on our car loans, credit cards, student loans, and other similar expenses. For companies in a growth phase or with a cash flow issue, the best option may be to borrow money with payment-in-kind (PIK) interest, a type of compounding interest with deferred payments.
Let’s look into how in-kind payments work, some common examples of PIK interest, and the difference between a PIK loan’s compounding interest and other types of interest.
What is payment in kind?
Payment in kind, or PIK, generally refers to using a good or service as payment instead of cash. This behavior is typically seen in bartering. For example, when two sets of parents start a babysitting co-op, they are paying for babysitting in kind rather than in cash.
If companies need to borrow money, either because they don’t have the cash for expansion or want to preserve their cash for other expenses, they may choose debt instruments with interest that can be paid in kind. This PIK interest does not have to be paid until the loan’s maturity date, but it does compound over time, resulting in a larger repayment to the lender taking on the extra risk.
What are examples of in-kind payments?
In order to understand PIK interest, it helps to understand how payment in kind usually works. Anytime someone is paid with a good or service rather than cash, they are receiving payment in kind — for example, a ski instructor who gets free lift tickets in exchange for lessons. Here are some common examples of in-kind payments:
People who participate in a barter exchange are essentially making in-kind payments. Bartering existed long before we had currency, and thus it can be considered the oldest form of commerce. Barter exchange platforms charge membership fees and allow members to trade goods and services.
Distribution of assets
After a person dies, their assets may be divided up and distributed based on the items’ fair market value. Thus, the recipients are paid in kind rather than receiving cash for sold items. Considering sentimentality and appreciation over time, the items may hold more value to the recipients than cash.
PIK interest for business loans
Businesses also use in-kind payments, particularly when they are in financial trouble or don’t have the cash to expand yet. In these cases, they can utilize PIK loans, or loans with interest paid in kind. This means that the interest on the debt will be added to the principal amount for a certain number of years rather than paid right away. The full amount of PIK interest accrued will be due when the loan matures.
Instead of paying its debt in cash, a company could also pay in kind with securities like stocks and bonds or equity in the company. PIK securities are a type of mezzanine financing that have high interest rates because of the risk to the lender or investors (they can lead to large losses in the event of a default). They are often used in real estate transactions or leveraged buyouts.
A PIK bond, for example, accrues interest in other bonds rather than cash. In the case of a loan with PIK interest accrued, the borrower may opt to pay interest in company stock rather than make a cash payment when it is due.
How does payment-in-kind (PIK) interest work?
The borrower pays extra interest in order to defer the interest payments until the loan matures. So PIK interest rates tend to be higher than they would be if the interest payments were made every month in cash. The interest also compounds based on the PIK beginning balance.
Compounding interest on PIK accrual
PIK interest compounds over time until the debt matures. This means that the interest accrues on top of accumulated interest, thus increasing the total amount due on the loan exponentially over time.
Consider an example of a $100,000 loan with 10% interest compounding yearly for four years. In the first year, the interest will be $10,000, increasing the principal to $110,000. In the second year, the interest will be 10% of $110,000, or $11,000, pushing the principal amount up to $121,000.
As you can see in the table below, by the end of the four-year term, the amount due will be $146,410. With so much interest accrued, the company is risking not being able to pay back the loan when it matures, but if it does, the lender will receive a large reward.
|Year 1||Year 2||Year 3||Year 4|
Variants of PIK interest payments
Instead of paying all of the interest in kind, a borrower may choose to pay a percentage of that interest in cash. This way, they are not stuck with the entire loan balance at the end of the term, but they still get to preserve some of their cash outlays. This is known as partial PIK interest.
Another option is for the lender and borrower to agree to a PIK toggle. As the name implies, the interest payments can switch back and forth between cash interest payments and payments in kind. If the company wants to conserve cash and activate PIK interest, it will have a higher interest rate than the cash payments.
How does PIK interest compare to other types of interest?
Interest is simply the cost of borrowing money. You probably pay various types of interest in your daily life, from auto loans to credit card bills to a mortgage. If you use a “buy now, pay later” service, you might have to pay interest on the installments. With most of these types of loans, though, you will be expected to make regular payments on the principal and interest. With PIK interest, you can defer these payments.
Compound vs. simple interest
As mentioned above, a notable feature of PIK interest is that it compounds, increasing interest exponentially. Credit cards also use compound interest, although it is usually compounded daily rather than annually.
Other types of loans feature simple interest, including car loans, some personal loans, and most mortgages. You pay the interest due each month, so it is not added to the principal. You will end up owing less interest over the life of the loan than if the interest was compounded.
Using the previous example of a $100,000 loan for four years, a simple interest rate of 10% would amount to $10,000 each year. When the loan matures, it will be worth $140,000 instead of $146,410.
What is payment-in-kind (PIK) debt?
PIK debt is a higher-risk type of debt in which the interest can be paid in additional debt, securities, or equity rather than cash.
What are examples of in-kind payments?
In-kind payments are made with goods and services rather than cash. Examples of in-kind payments can be as simple as two friends trading clothing items or as complex as a company taking out a $1 million loan with compounding PIK interest.
How do PIK loans work?
When a business takes out a PIK loan, the lender agrees to take a deferred payment rather than traditional cash interest. This includes accrued interest and can potentially be paid in PIK securities. The lender may charge a higher interest rate to mitigate the risk involved and the delay in receiving cash payments. The interest also compounds over time, increasing the principal due when the loan matures.
Who can receive in-kind payments?
Anyone can receive an in-kind payment, as long as they receive payment as a good or service rather than cash. Banks and other lenders may receive PIK interest for loans, and investors may receive preferred securities instead of cash for their investments.
Does payment-in-kind interest compound?
PIK interest is compounded over the term of the loan and does not have to be paid until the loan matures.
- Payment in kind refers to a payment made with goods and services rather than cash. Before currency existed, people made payments in kind by bartering.
- Businesses in a growth phase or otherwise tight on cash can take out a loan with PIK interest. This allows them to pay back the accrued interest at the end of the loan term and keep their cash on hand in the meantime.
- Due to the risk involved, PIK interest rates can be higher than other types of interest.
- PIK interest compounds over time, so the principal amount increases each year of the loan term. If this balance gets too high, borrowers may have trouble paying back the loan.
- Variations on payment-in-kind interest include partial PIK interest (in which a percentage of the interest is paid in cash) and a PIK toggle (when a borrower can go back and forth between a cash interest payment and a deferred payment).
View Article Sources
- Topic No. 420 Bartering Income – IRS.gov
- About Form 1099-B, Proceeds from Broker and Barter Exchange Transactions – IRS.gov
- In-kind – Legal Information Institute, Cornell Law School
- 5 Tax Rules for Deducting Interest Payments – U.S. Small Business Administration
- About Form 8990, Limitation on Business Interest Expense Under Section 163(j) – IRS.gov