What is a bond and how does it differ from a loan?
In: Economics
A bond has a fixed repayment schedule in which only interest is paid for the term on the bond. Then, when the bond comes due, the debtor has to repay the face value of the bond in one lump sum.
So, imagine you buy a 10 year bond with a 10% interest rate, paid once per year. This bond cost you $100. You will be paid $10 per year, each year for 10 years. At the end of year 10, you will be paid one final payment of $110 – the $10 in interest you were owed plus the $100 you initially paid for the bond.
That payment structure is pretty much fixed with a bond – every bond will have a face value that was initially paid for it, an interest rate, a frequency of interest payments, and a maturity date on which the final payment is owed. The debtor also can’t speed up the payments unless the bondholder consents. So, using the above example, the debtor can’t make a $20 interest payment one year to reduce the amount of interest they owe in subsequent years.
A loan has a more open ended payment schedule that, in theory, never has to be paid off. All a loan requires is that you pay interest on the remaining balance of the loan at a specified frequency. If you want to pay more you can, which will reduce your future interest payments. Some loans also let you pay less, in which case the balance of the loan simply increases.
So, imagine that you loan someone $100 with a single 10% interest payment each year. Each year your borrower just needs to pay you $10 to be current on the loan. If they want to pay you $10 per year for the rest of eternity, they are entitled to do that. But the debtor can also choose to pay you $70 at the end of year 1. This covers the $10 in interest that they owe, as well as $60 of the loan’s original balance, reducing it from $100 to $40. Now they only owe you interest on that remaining $40 at the end of year two – which would be $4.
Because loans are more open ended, they will sometimes contain provisions that allow you to be considered current even though you aren’t making payments on them. They also will sometime contain provisions that allow the lender to “call” the loan, which forces the debtor to pay back the entire principle balance at once.
Most consumer loans have what’s called an amortization schedule, which is a schedule of fixed payments that will result in the loan being paid off over a certain amount of time.
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