Non-amortization loan

Definition

A non-amortizing loan, also known as a bullet loan or interest-only loan, is a type of loan where the borrower is required to repay only the interest on the principal amount borrowed throughout the loan term.

What is a non-amortisation loan?

Unlike traditional loans, which require periodic payments that include both principal and interest, non-amortizing loans typically involve making interest payments over the loan term, with the principal amount due in full at the end of the loan term.

Non-amortizing loans are commonly used for short-term financing needs or as bridge loans to finance projects or investments with expected cash flows or refinancing options in the future. They are often favoured by borrowers who expect to have sufficient funds available to repay the principal amount by the end of the loan term.

These types of loans typically carry higher risk for lenders compared to traditional amortizing loans since the entire principal amount is due at maturity. Lenders may require borrowers to meet specific criteria or provide collateral to reduce this risk.

Non-amortizing loans offer flexibility for borrowers who may prefer lower monthly payments during the loan term, allowing them to allocate funds for other purposes or investments.

The interest rate on non-amortizing loans may be fixed or variable, depending on the terms negotiated between the borrower and the lender. Borrowers may benefit from lower initial interest rates compared to traditional loans, but they should be aware of potential interest rate risk if rates rise during the loan term.

Example of non-amortisation loan

Let’s say a real estate developer, ABC Properties, is constructing a commercial building and needs short-term financing to cover construction costs. ABC Properties obtains a non-amortizing loan from a lender, XYZ Bank, to finance the project.

The terms of the loan agreement specify the following:

• Principal amount: $1,000,000
• Loan term: 24 months
• Interest rate: 6% per annum

Throughout the loan term, ABC Properties makes monthly interest payments to XYZ Bank based on the outstanding principal balance of $1,000,000 at a 6% annual interest rate. The interest payments cover only the accrued interest on the loan and do not reduce the principal balance.

At the end of the 24-month term, ABC Properties is required to repay the entire principal amount of $1,000,000 to XYZ Bank as a lump sum or balloon payment. ABC Properties may plan to repay the principal amount using proceeds from the sale or refinancing of the completed commercial building.